Friday, June 12, 2009

Inflation Expectations = Reality for Interest Rates

I've been very busy and haven't posted for a while, but mortgage rates have me concerned.Yes, they are low based on historic averages, but they are not low enough NOW. 
As most people know, the price for debt in the T-bond market is determined by inflation expectations. If investors expect the value of the dollar to decrease they demand that Treasury bonds to yield more. Mortgage securities compete with 10 year T-bonds (since the maturity is about the same on average) hence the historic correlation between their rates.  Mortgage backed securities investors typically get a higher yield from MBS because you and I are more likely to default than the US Government (hopefully).  So, mortgage rates are almost always a little higher (more or less) than 10 bonds.
As far as I can tell, unfounded inflation expectations are what is driving up T-bond, and hence mortgage, rates.  However, as Paul Krugman explains, interest rates should not be rising because there is an excess in global savings looking for a place to go - money should be cheap. This should keep interest rates down.  What's going on?
The answer must be risk.  The risk of inflation (percieved or not) in the bond market, and the investment risk in the corporate market is keeping rates higher.  While expectations of growth are good on the one hand, higher mortgage rates could choke the economy.  The current 30-year fixed rate of about 5.6% is still pretty low, but it can't go much higher to quickly.