<< Bond market continued from Page 86 “One sign of a coming recession is when the
yield curve inverts — when the 30-year yield
is less than the 10-year yield.”
To understand why inflation trends, and perceptions
about inflation, are so important, think like someone
with $100 million in liquid assets. If you’re wealthy,
own your own home and have little debt, the goal of
your investing strategy typically is to ensure you can
buy as much stuff with that $100 million in the future
as you can buy today.
You have only one enemy — inflation. Consequently,
you invest in fixed-income securities: corporate bonds,
Treasury debt, and mortgage-backed securities.
If inflation is running at 2 percent, and your average
return equals or exceeds that mark, your $100 million
is not losing any future purchasing power. If inflation
rises, however, you will want better returns to protect
As a result, fixed-income securities like Treasurys
are going to need to offer you higher yields in order
to get your attention. Since mortgage rates move with
the 10-year Treasury yield, one consequence of rising-inflation fear is that Treasury yields will rise to attract
buyers, and that means mortgage rates rise as well.
The yield curve
One variable related to mortgage rates in 2018 that
merits attention is the shape of the Treasury yield
curve. The yield curve is a graph with debt-security
duration on the horizontal axis and debt-security
yield on the vertical axis. The yield curve is described
as flattening when shorter-term yields move closer
to long-term yields. As 2018 got underway, the yield
curve was trending flat.
One sign of a coming recession is when the yield
curve inverts — when the 30-year yield is less than the
10-year yield. The 30-year Treasury yield may fall as
fear of a recession causes pension managers to move
assets from equities to long-term Treasurys. More buying, or demand, at the long end increases prices for
those debt securities but depresses yields.
Also, speculative investors who think a recession
is coming may not invest their money in short-term
securities because they are betting interest rates will
decrease in the near future. Lower Treasury rates usually translate into higher demand and rising prices.
So, speculative investors move toward long-term ( 30
year) bonds because those long-end plays will offer the
most upside with respect to bond-price increases.
Again, significantly more buying, or expanding demand, at the long end of the market eventually puts
upward pressure on bond prices but reduces yields.
It is important to understand the mechanics of the
bond market and stay on top of major economic-data
releases that can affect the market. Then you can keep
your risk-averse borrowers informed about these
events so they have an opportunity to lock in their
rates. This will go a long way to ensuring that your
clients are well-served and happy. ■
is inevitable, but when it happens, it needs room to
lower the federal funds rate. The Fed’s preparation for
a potential recession may be construed as a forecast,
but it is not that. It is more like buckling your seat belt.
It is a precautionary measure.
The long game
There are three things that move yields on Treasury
securities: actions by the Fed, the foreign-exchange
value of the U. S. dollar and, most importantly, percep-
tions about inflation. The key thing here is the word
Trades are based on interpreting fundamental data
and what Federal Reserve monetary policy will do
to inflation in the near future. Few people have a
broad enough vision of the economy to make correct
decisions about purchasing fixed-income securities,
In reality, the bond market is made on the margins.
Well-informed people tend to buy and hold, while
those less well-informed make shorter-term decisions
based on reporting in the financial media. Often the
effect of the latter is to cause overreaction.
and noncompetitive. Most individual investors pur-
chase Treasury securities by submitting a noncompetitive bid. By placing a noncompetitive bid, you
are guaranteed an average yield and equivalent price
determined by the competitive auction.
Competitive bidding is generally done by large
financial institutions and brokers familiar with the
securities market. As a competitive bidder, you must
submit a sealed bid specifying to three decimal places
the rate you are willing to accept. All noncompetitive
bids will be accepted for that auction. The remaining
balance of the offering is allocated among competitive bidders, beginning with the lowest yield (highest
price) until the total amount needed is satisfied.
The bond market
Once the Treasury notes and bonds are issued and distributed, investors buy and sell these securities
through a cash market called “the bond market.” One
of the confusing things about the bond market is
that the yield on the securities moves in the opposite
direction to their price.
Take a 30-year bond at a coupon rate of 3. 5 percent,
for example. If it closed trading at a 110 19/32 bid, then
for every $1,000 face value of bonds, someone was
offering $1, 106. Divide the 3. 5 percent coupon rate by
1.106 and you get 3. 16 percent.
That means the bond yield is 3. 16 percent. When
the price of a bond moves up, the yield moves down.
In the example provided, the rate at which you receive
payment on the bond is still the coupon rate of
3. 5 percent, but because you paid a premium to get
that 3. 5 percent, the yield is actually 3. 16 percent.
The Federal Reserve
The nation’s central bank, the Federal Reserve, is not
allowed to purchase Treasury debt directly from the
Treasury Department. It must do so on the open market. This enables the Fed to control money supply.
By purchasing Treasury debt on the open market,
the Fed can increase money supply by crediting the
account of the bond seller with money that did not
exist previously. The prior holders of the Treasury debt
purchased by the Fed now have cash.
Conversely, by selling Treasury debt on the open
market, the Fed can decrease money supply. After a
bond sale, the Fed receives the cash from the buyers,
and that cash is no longer part of the nation’s money
supply. It essentially disappears, thus decreasing
Much is written about the role of the Fed regarding
interest rates, but the important thing for mortgage
originators to remember is that apart from home
equity lines of credit, or HELOCs, that are based on the
prime rate, the Fed has little direct control over mortgage rates.
When the Federal Reserve is moving the federal
funds rate up or down, the effect will be seen primarily
on shorter-duration Treasurys (those with maturities
less than five years). Practically speaking, the Fed controls the short end, but the market controls the long
end with respect to rates, and it is the longer end that
drives mortgage rates. Mortgage rates generally move
in harmony with the 10-year Treasury yield.
Fed rate hikes are, essentially, preparation for a
recession. The Fed may not believe that a recession
How to stay on top
of the bond market
Pay some attention throughout the day to the yield
on the 10-year Treasury note. Monitor releases
of macroeconomic data that can move markets,
including the following:
■ ■ The Consumer Price Index (inflation);
■ ■ Gross domestic product (economic growth);
■ ■ Retail sales;
■ ■ The U.S. Bureau of Economic Analysis’ Personal
Income and Outlays report; and
■ ■ The U.S. Bureau of Labor Statistics’ Employment