Rates Can’t Go Any Lower … Right?

Back in January, here’s what we said about rates and the economy:

“As we move through 2010, our outlook is for waning Fed support to push rates approximately 1% higher, and for a choppy economic recovery marked by modest GDP growth and minimal employment improvement.”

Conforming 30-year fixed rates were at 5% at the time. At this July 14 writing, rates are much lower at 4.57%. Clearly our rate view was conservative but at least our economic outlook is still accurate, and at least rates are lower.

Actually rates have never been lower since Freddie Mac began keeping official records in 1971. On May 27 and June 3, 2010, rates touched on previous record lows of 4.78% set in two other times in 2009. Since then, rates have dropped to a new record low of 4.57% as of July 8, 2010.

Below we explain how rates got this low, and why it’s unlikely rates can go lower. And here’s a post explaining which rates we are discussing, which will help you interpret the news you read daily.

Why Rates Are So Low
In an unprecedented rate stimulus exercise from January 1, 2009 through March 31, 2010, the Federal Reserve bought $1.25 trillion in mortgage bonds. Rates are tied directly to mortgage bonds, so when those bond prices rise on buying rallies, yields (or rates) drop. Fed buying was the reason new record rate lows were set in 2009, and rates were only about .2% above those lows when the Fed ended its program March 31.

Then about one month later on May 6, Greek parliament voted to increase taxes and cut spending (including wage cuts for about 20% of their workforce) in response to a severe debt crisis, and rioting on their streets ensued. That caused a brief 1000 point drop in the Dow stock index, and even though U.S. stocks recovered from that initial shock, European bonds have taken big losses as Greece’s debt crisis spread throughout Europe.

On top of this, the U.S. economy has been choppy. We’ve seen weaker new and existing home sales data for the past 2 months. The economy lost 125,000 jobs in June, and unemployment is at 9.5%. And the final reading for first quarter GDP (released on June 25) showed that the economy grew at 2.7%, which was .5% lower than the initial April 30 reading.

The market result of U.S. and European uncertainty has been heavy buying of mortgage bonds (and Treasury bonds) since they’re considered the safest investments relative to European bonds and other investment options globally.

Mortgage bonds have steadily risen from Fed-induced March 31 highs to staggering new heights. This is why rates are so low.

Can Rates Go Lower?
Back in January 2010 we got the economic call right but didn’t anticipate that European debt issues would push global investors into mortgage bonds, causing already record low rates to go even lower.

At the time, we noted that Bill Gross, head of PIMCO, the world’s largest bond manager, had been saying publicly since January 2009 that investors should buy mortgage bonds ahead of the Fed and sell before the Fed sells.

We thought the global selling of mortgage bonds might come sooner and push rates higher. For now though, mortgage bonds are viewed as the safe play. But even PIMCO, who directly benefits from this unprecedented historical rally in mortgage bonds, agrees it can’t stay like this.

“It’s gotten insane,” said PIMCO mortgage backed securities head Scott Simon when asked about mortgage bond price levels on June 24, 2010. “This is rarefied air.”

So can rates go lower from here? The short, and conservative, answer is No.

The longer answer is that rates could hover close to current levels for a few more months if the economy continues to stagger. But if we do see a few consecutive months of economic improvement, mortgage bonds will sell off from record levels, and rates will rise.

Rate Volatility Goes Two Ways
Markets are extremely volatile as we complete this third year of the financial crisis. For now, that volatility is working in the favor of rate markets, providing amazingly favorable loan terms for homebuyers who are ready to transact and homeowners who qualify for refinances.

But consider the simple dictionary definition of volatility: liable to change rapidly and unpredictably.

So if there ever was a time to capture market volatility when it’s working in your favor, this is the time.