The Rate Picture For 2006

Welcome to the new year … a time when people on main street pull up their blogs and start typing up resolutions; and a time when people on Wall Street pull out their darts and start aiming at market charts.

Of course, we’re using the dart analogy in jest. It’s based on a long-running Wall Street Journal column called Investment Dartboard in which readers’ stock picks compete against stocks picked by WSJ staff members tossing darts at newspaper stock listings.

Predicting rate markets can sometimes feel like throwing darts at the yield curve, but there’s definitely a science to it. So we’re kicking off 2006 with a two part story on the year’s rate outlook. This first installment is being written before any Wall Street predictions for 2006 have been released, so it will talk about how to interpret interest rate data. This will give you some context for February, when we will discuss Alan Greenspan’s successor, summarize Wall Street rate estimates, and make our own predictions.

How Are Mortgage Rates Derived?
Let’s start by talking about why mortgage rates have been low for the past few years. It’s because the economy was performing poorly, and this caused two things to happen: (1) investors flocked to bonds as a safer investment than stocks, and (2) the Federal Reserve lowered the Fed Funds Rate to an all-time low.

Since most mortgages are eventually packaged into bonds, mortgage rates are tied to bond yields. A yield is the rate of return an investor gets on a bond, and this yield goes down proportionally as bond prices go up. So that’s exactly what demand for bonds did in the past few years: it pushed bond prices up, and pushed the yield (or rate) down. This is the first reason mortgage rates were low.

The second reason for low mortgage rates in recent years is the sinking Fed Funds Rate. The Fed Funds Rate is an overnight lending rate that Federal Reserve banks charge each other to balance out reserves each day. Even though Fed Funds is not a consumer nor commercial rate, it’s movement helps set the tone for the cost of money in our economy.

“Setting the tone” is the whole point of the Fed’s role: they move this rate down to stimulate the economy, and move it up to keep prices in the economy from growing too quickly and causing inflation. This impacts all rate markets from bond yields to business loans to consumer credit cards. So while most mortgage rates are not tied directly to Fed Funds, they are influenced by Fed Funds movement.

The Fed vs. The Open Rate Market
Now that we know how bond yields and Fed Funds affect mortgage rates, let’s apply this to the past 18 months. By late-June of 2004, the Fed sensed their prior rate decreases were stimulating the economy as planned, so they started hiking the Fed Funds Rate up from 1%. At that exact same time, we had a yield of 4.70% on 10-year Treasury bond, which is a common benchmark for the intermediate to longer-term rate complex.

Fast forward to today. The Fed Funds Rate is all the way up to 4.25%, while the 10-year Treasury is trading around 4.50%. This proves that mortgage rates are not directly tied to Fed Funds. If they were, mortgage rates would be 3.25% higher than they were in June 2004.

But more importantly, this illustrates an interesting conflict between the Fed and the open market. Fed Funds rose 3.25%, but the Treasury didn’t take this queue and stayed the same. Clearly, the bond market has less confidence in the economy than the Fed. We should also point out that the mortgage bond market, which is what mortgage rates are tied to, have followed the same general trend as Treasuries. For broad illustrative purposes, we use Treasuries, and in our Marketweek coverage of mortgage rates, we use mortgage bonds.

For now, this Treasury market defiance is good for mortgage rates. And perhaps the conflict will be reconciled when Ben Bernanke takes over for Alan Greenspan as Fed chairman next month. Maybe he’ll start easing off Fed Funds, which would also be good for rates.

We’ll discuss these issues along with our rate predictions in Part 2 of this piece next month.

How Did Our Predictions Do Last Year?
As for our predictions last year (Part 1 here, Part 2 here)… we said that 30yr fixed Jumbo rates would be at 6.625% versus 5.875% at the time, and they’re currently at 6.275%–we were off by .25%. We said that 5yr ARM jumbo rates would be at 6.5% versus 5.25% at the time, and they’re currently at 6.125%–we were off by .375%. Not bad, and not great either. Just like a game of darts.