Special Report: Coronavirus and Rates | March 5, 2020 As the number of reported cases of the coronavirus around the world has increased, the list of school closings, work interruptions, event cancellations, and other consequences has grown. This decline in economic activity has been brutal for stocks but good for bonds, pushing rates to record low levels. One commonly heard question, though, is why mortgage rates have not fallen as much as government Treasury yields. There are two main reasons. First, mortgage-backed securities (MBS) have prepayment risk while Treasuries do not. When people refinance, their loans are removed from MBS. This makes MBS less valuable to investors relative to Treasuries during periods of declines and more valuable during periods of increases. In other words, mortgage rates rise and fall more slowly than Treasury yields due to the basic properties of prepayment risk. Second, the large mortgage companies which purchase loans and set mortgage rates have the capacity to process only so much business at one time. Currently, there is more demand for loans and refinancings than these firms can handle, so they have less incentive to pass along the lowest possible rates to customers. Here are some actual figures from [...]
In her semi-annual testimony to Congress, Fed Chair Yellen said that the Fed expects that economic progress will call for "further gradual increases" in the federal funds rate. She also said that it would be "unwise" to wait too long to hike rates. Yellen later added that the Fed will consider in coming months when to begin to reduce the Fed's holdings of MBS. Of note, she said that the Fed will not sell MBS to shrink the holdings, but rather will stop replacing principal reductions. The expected pace of tightening by the Fed increased a little after her testimony, causing MBS to decline.
President Trump today said to expect an announcement about tax cuts in two to three weeks. Mortgage rates moved a little higher after the comment. There are two reasons why tax cuts are viewed as negative for mortgage rates. The first is that tax cuts increase the wealth of the affected individuals or businesses, leaving them with more money to spend. This added spending boosts economic activity, which increases the outlook for future inflation. Mortgage rates rise as expected future inflation rises, since higher inflation further erodes the value of a mortgage’s future cash flows. The second is that tax cuts increase the budget deficit, at least initially. This means that the government has to issue more Treasury bonds to fund the deficit. The added supply reduces the value of Treasuries and similar bonds, including mortgage-backed securities (MBS). A decline in MBS prices leads to higher mortgage rates.
Next Sunday, voters in Italy will decide on a referendum presented by Prime Minister Matteo Renzi which would reform the constitution to speed up lawmaking and to produce a more stable government. If the referendum fails to pass, there is the potential for many troubles to develop in Italy. First, much needed reforms for the Italian banking sector likely would be postponed, which would put many banks at risk of failing. Investors are concerned that this could impact banks throughout Europe. In addition, Renzi has said that he will step down if the referendum does not pass. His resignation would likely lead to a period of political uncertainty in Italy, and it could result in more power for a political group which favors leaving the euro. In the wake of the Brexit vote in the UK, investors would be very concerned if they saw the potential for Italy to exit the European Union. The most recent polls show that it may be a very close vote. Investors have reacted to the uncertainty by shifting to safer assets, including U.S. mortgage-backed securities (MBS). Since mortgage rates are set based on MBS prices, the news resulted in improvement. For the rest of [...]