A special update from David Battany, EVP Capital Markets
- What is the #1 daily driver that causes interest rates to go up or down? If an economic news release such as the unemployment rate, new housing starts or the orange crop forecast comes out better than expected, bond prices will drop and interest rates will go up. If it comes out worse than expected, bond prices will rally and interest rates will go down. Almost every business day, various government and industry economic reports are published. The financial markets know the scheduled release dates and predict their expectations for each report. If the actual announcements come out better or worse than expected, the markets react. Good news for the economy is bad news for bond prices, causing rates to go up, and, bad economic news causes bond prices to go up and interest rates to go down. Interest rates always move in the opposite direction of bond prices.
- Did the bond market overreact to the election and will it return to its previous levels? The market is still searching for its new equilibrium point, so it is too early to determine if the market overreacted, or if the current, or even higher rate levels will be the new normal. It is safe to say that a market with 30-year fixed rates in the 3s is not a normal market equilibrium level, and was due to the U.S. economic recession and the government’s stimulus efforts to lower rates to help the economy recover. This was not a long term sustainable level for interest rates. There is a very strong possibility that the market is now in the process of moving to higher interest rates as the new normal.
- What key components cause interest rates to go up or down?
- Overall Economy. If the Gross Domestic Product of the overall economy improves, interest rates will go higher. If the economy declines, interest rates will usually go lower.
- Income Tax Rates. If the individual or corporate tax rates are reduced, this will increase the need for government borrowing, at least in the short run, putting upward pressure on interest rates.
- Infrastructure Spending. If the new administration increases infrastructure spending, this will increase government borrowing, and cause interest rates to increase.
- Inflation. If the inflation rate, which has been hovering around 2%, begins to increase, this will directly cause interest rates to increase. The Federal Reserve is targeting a 2% inflation rate and will raise the Fed Funds rate if they see inflation going over 2%.
- Federal Reserve MBS Purchases. The Fed was a very large buyer of MBS as part of the government’s economic stimulus efforts known as Quantitative Easing, which significantly lowered interest rates for mortgages. The Fed has reduced the amount of MBS they buy each month, only buying the amount equal to the payoffs on their existing $1.7 Trillion MBS portfolio. However, the Fed is still one of the largest buyers of MBS and their buying continues to have downward pressure on interest rates. If overall rates rise, and refinances drop off, the Fed will have fewer payoffs of their existing MBS portfolio, and therefore have fewer funds to buy new MBS, which would then remove the downward pressure on interest rates.
- Fed Funds Rate. If the Fed Funds rate increases in December, it will likely have little or no impact on overall rates since it only applies to overnight loans to Fed member banks, and an increase is already priced into the market’s expectations. However, a series of increases would signal the market that government policy makers view the economy as improving, and overall market rates will soon begin to increase.
- Is the 10-year Treasury Note a good barometer of the mortgage market? Usually, yes. It is a very liquid and transparent market indicator and most bond market participants monitor the 10-year yield as a barometer for where mortgage interest rates are going. However, if the government increases its total borrowing, more Treasury securities will be issued, and if mortgage interest rates increase and total mortgage industry volume declines, fewer MBS will be issued, leading to a supply/demand imbalance between the 10-year Treasury and MBS. This would lead to the historic price spread changing. While it is still a good barometer, note that MBS prices will not always move in perfect lock step to the 10-year Treasury price changes.
- When is the best time to lock in a rate commitment? All else being equal, the best time to lock in a rate commitment is before 1:30 PM Pacific Time on a regular business day. The U.S. bond markets close at 2:00 PM PT, however the last 30 minutes of the trading day typically have poor trading liquidity, which translates to poor pricing. Lenders immediately sell MBS or cash trades whenever new rate lock commitments are received, which allows the lender to lock in the price quoted on their rate sheet with the investor who is buying the loan. When a loan is locked after 2:00 PM PT, lenders are unable to hedge with MBS and many whole loan investors shutoff or worsen their pricing. All else being equal, the higher hedging costs after 1:30 PM PT will cause rate lock prices to worsen, so you are usually better off locking earlier in the day. As you may have noticed in recent months, most mid-day price changes are for the worse, which is another reason why locking early in the day is usually a better price than locking in later in the day.
- What is the best strategy when to lock loans near national holidays? Most Wall Street bond trading desks close early the day before a major U.S. national holiday, particularly if it is a three day weekend. Often, only junior traders are present on the day of the early market close, and it is very common for the market to only actively trade for the first few hours of the day. The bond desks worsen their pricing in an attempt to avoid conducting more business for the rest of the day so the traders can leave early for vacation. The best strategy to lock near a national holiday is to lock when the market trading is most liquid, which is in the morning of the day before the early close. If, for example, Monday is a national holiday, most trading desks will close early on the Friday before, making Thursday morning your best time to lock. If you miss the Thursday morning opportunity and have to lock on Friday, you are usually better off to lock in the very first hour of the business day, as the pricing typically worsens later in the day.
- Can rate-lock advisory firms time the market’s movement and tell you the ideal moment to lock? No. U.S. bond markets are very efficient markets and no individual or firm can accurately predict market movements and timing. Most rate lock alerts are simply generated when the market has already dropped 25 basis points in price. This is akin to a weather forecaster predicting rain after the rain drops have started to fall. In volatile markets, most lenders and investors will already have worsened their pricing, so borrowers are now getting locked in at a 25 bps worse price than if they locked earlier in the day. Any rate lock alert has only a 50/50 probability of predicting if the market in the following days or weeks will be better or worse than the current market. There is an important distinction between trying to make your locks when the markets are most liquid and pricing is generally the best, versus trying to predict market direction from day to day.
- Is it important to extend a commitment before it expires? Yes, particularly when interest rates are rising. If a rate lock commitment is extended before its expiration, the corresponding MBS trade that was sold to hedge the rate lock can easily be extended for a very small fee. If the rate lock expires, the corresponding MBS trade is paired off or has a new loan assigned to it. That means that if the original loan is then relocked, it now has to be priced into a new MBS trade, at the current market price.
- What is a Zombie lock and how do we get rid of it? A zombie lock is a rate lock commitment which has been made and the borrower later is unable or unwilling to close the loan, however, the lock is not cancelled in the system. This causes the loan to continue to be hedged, even though the probability of the loan closing is zero. The hedging of a loan costs a lender on average between 12.5 and 25 basis points per loan, so reducing zombie locks reduces hedge costs, which translates to improved daily rate sheet pricing. Lenders will have different strategies for reducing zombie locks.
10. Should I adjust my rate locking strategy for the upcoming six months? Probably. It is likely we are moving from a bull market to a bear market in terms of bond prices, which if true, should cause a change in strategy. In the last few years, daily bond prices have improved more often than they have declined. For borrowers willing to take the risks of floating, they often came out ahead. This may be the opposite going forward. When bond prices improve, it is usually by small amounts over many days, but when they worsen it is often by large amounts in a few days. If we are beginning the long-predicted rise in interest rates to more normal market levels, then most borrowers, particularly purchase borrowers would benefit from locking rather than floating.