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August 13, 2012

“Fiscal cliff”: The long-term outlook for mortgage interest rates

by Rylan Stewart
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[UPDATE:  Please go HERE for a comprehensive look at the affect of the "fiscal cliff" - a combination of government spending cuts and tax break expirations to go into effect on January 1, 2012 - on the real estate market and mortgage rates. We have also included a brief overview of the situation. For the article, please see: How the Fiscal Cliff will affect Mortgage Rates, real estate market.]


We have written here about the historical relationship between the benchmark 10-year U.S. Treasury bond yield and the 30-year fixed mortgage rate – a 1.5 percent spread between the two. Regular readers of our posts will know that interest rates have lagged behind the yield for months now. With concern about Europe and the U.S. economy moving investors to the “safe haven” of US Treasuries, the price for 10 year-bond has increased (due to more demand) and the yield (moving inverse to price) has dropped off the table.

Last Friday, the yield for the 10-year closed at 1.659 percent after the stock market built a four-day rally. During moments in the last several weeks, however, the yield dropped below 1.500 percent. With interest rates like these, you would expect to see rates fall to 3.000 percent for the 30-year fixed. However, while we have seen some downward pressure (the 3.250 percent 30-year fixed is now available), we have not seen the 30-year fixed drop as we might have expected in the past.

Tim Manni at HSH, a leader in Mortgage and Real Estate news, published his take on the matter, “There is much less of a lockstep relationship between the two instruments than at other times over the last 10 to 20 years. Furthermore, with the Federal Reserve manipulating the market, there is no longer a true expression available, regardless.”

This decoupling may be true to some extent. On the other hand, both mortgage rates and the 10-year Treasury yield have experienced record lows, and the low interest rate environment created by the Fed is still getting priced in. Homeowners have flocked to refinance, and with the frenetic pace of business, banks have little incentive to lower rates and attract still further business. Furthermore, with rates so low, banks have less incentive to offer loans in the first place, because they are opening up to risk with very little reward – such low interest rates offer increasingly small profit margins.

The most important event to consider for the future movement of interest rates is the so-called “fiscal cliff” at the end of the year, which is when about $500 billion in tax cuts and spending boosts are set to expire and we will rely on our elected officials to sort out the mess and avoid another recession. Do you all recall what happened last time the government faced a fiscal dilemma? The debate about whether to increase the debt limit caused markets to take daily triple-digit swings. If this debate goes down to the wire (and it will), investors will flood to the U.S. Treasuries to protect agains the unstable stock market.

Will this translate to lower interest rates? Historical speaking, the evidence would suggest that interest rates would fall even lower. However, this situation would be without historical precedent, so we don’t want to make any sweeping statements. Our advice: don’t wait for mortgage rates to drop lower. While possible mortgage rates could drop, there is too much future uncertainty to pass up the present record low rates.

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