In my last blog post about two months ago, 10-year Treasuries were yielding about 1.10%, mortgage rates were still declining, and I said that there was no need to fret yet. With the passage of the $1.9 trillion American Rescue Plan and its effect on interest rates, caution is now warranted, especially in the refinance space, where a slowdown is already evident. Moreover, President Biden and Congress have begun discussions regarding an infrastructure spending bill that could top $3 trillion. If a bill anywhere near $3 trillion becomes law, interest rates will jump, killing off mortgage refinance activity and possibly harming purchase activity as well. Over the last few months, refinancing has represented almost 70% of total mortgage origination activity, so an infrastructure bill could be damaging to the mortgage industry.

The yield on 10-year Treasury notes bottomed late last summer and began trending upward along with expectations of an economic recovery. However, the trend accelerated in February as stimulus plans firmed and the ARP was signed into law. In my last blog post I also showed the spread between 30-year mortgage rates and 10-year Treasuries. That spread is now as narrow as it has been since 2014 thanks to the Federal Reserve’s purchase of $40 billion in agency MBS per month, preventing MBS yields from rising as fast as Treasury yields. Also supporting agency MBS yields and mortgage rates is the fact that as banks sell Treasuries to the Federal Reserve in its quantitative easing program, some of them are using the proceeds to purchase agency MBS.

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Aside from many expensive provisions that can hardly be described as stimulus spending and will not take full effect for several years, the bill provides $1,400 direct payments to individuals earning under $75,000 a year and couples earning less than $150,000. The bill also has provisions to extend assistance to renters as well as homeowners in danger of foreclosure. Overall, though, the bill will have relatively little direct impact on the mortgage market. The indirect effect, operating through the interest rate channel, will have clearly adverse effects on refinance activity. While rates are also rising in response to expectations for a stronger economy as the vaccine rollout continues, the fact that rates jumped so much right around the time passage of the ARP seemed all but guaranteed tells me the bond market was reacting to the unprecedented level of government spending.

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Despite the rise in rates, the housing market remains active. The sharp drop in February’s MBA purchase activity index fell sharply is primarily due to severe weather over much of the country that prevented buyers from getting out and visiting homes for sale. Of course, higher interest rates do dampen demand for housing, but a variety of other factors like household income, demographics, and expectations for an improving economy also drive demand. Moreover, with work-from-home arrangements more likely in a post-COVID world, many families are trading in smaller urban homes for larger suburban homes. Hence, while higher mortgage rates will act as a damper on purchase activity, other factors suggest purchase activity will remain healthy.

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Refinances are must more sensitive to interest rates, as the propensity to refinance is driven by the difference between the rate on existing mortgages and current interest rates along with upfront fees associated with doing a refinance. As we see in Figure 3, refinance index activity has slowed considerably the last couple of months, just as mortgage rates have jumped. While the MBA refinance index is still elevated and within 2020’s range, if mortgage rates continue to rise, refinance volumes will undoubtedly suffer. Figure 3 also shows how refinance activity slowed substantially in mid-2013 and late-2016 as mortgage rates mortgage rates jumped.

Right now, there are two policy options being discussed, one that would be positive for the mortgage market and one that would be unambiguously negative.

If the Federal Reserve becomes concerned about the run-up in longer-term interest rates and, more specifically, the steepening of the yield curve, it could resurrect “Operation Twist,” a program used in 2011 to move longer-term rates lower at the expense of higher shorter-term interest rates. In such an operation, the Federal Reserve would sell Treasury notes with, say, maturities under five years and use the proceeds to purchase longer-term Treasuries. The advantage to doing another twist, as opposed to a simple increase in purchases of longer-term maturities is that the Fed’s balance sheet does not grow and it may create fewer side effects for banks who have to deal with excess cash when they sell Treasuries.

Washington insiders are dangling the prospect of an infrastructure investment bill that could carry a price tag as high as $3 trillion. As discussions progress and the likelihood of legislation occurring increases, we will see Treasury yields rise. Moreover, that rise could be substantially given the sharp jump seen just in the past two months thanks to the stimulus package. While much of the nation’s infrastructure certainly needs to be refreshed, committing to such a large investment all at once would certainly put upward pressure on interest rates, curtailing refinance activity and possibly slowing home purchases.

In summary,

  • The recently passed stimulus package has led to higher mortgage rates, slowing refinance activity.
  • Purchase activity remains healthy despite the higher interest rates, and it has the winds of an improving economy and demographic trends at its back.
  • The Fed does have another tool in its pocket to slow the increase in longer-term interest rates if it decides to use it.
  • If recent infrastructure spending talks continue and lead to the passage of a bill, the rise in Treasury yields will accelerate even faster and slow refinance activity substantially.