The low rates of the past few years were an anomaly, a combination of abnormally low interest rates and Federal Reserve intervention in the bond and mortgage-backed securities market. Now the Fed has ended quantitative easing and is raising rates. But what really matters is what happens to the 10-year bond yield, because that’s what drives mortgage rates. And like mortgage rates, the yield on 10-year bonds has been rising recently, hovering just below 3% at last count. But that return is also still low, by historical standards.
Until very recently, many financial macroeconomists put their money (if they were actively betting on the market, which they don’t) on the 10-year upside. The financial literature assumes that bond prices revert to the mean, or that they may rebound for a few (or more) years, but in the long run they will revert to a historical average that reflects how much people want to save versus spend. – with the idea that the desire to save should be fairly stable over time. Moreover, unlike equities, bond prices cannot continue to rise, otherwise we would end up with very negative returns; few investors would accept a return of -10%. So since the 1990s, mean reverting devotees have been waiting for the yield on 10-year bonds to return to its historical average of around 6-7%.
We are still waiting. After nearly 40 years of declining yields, our faith has been tested. If the 10-year means coming back, it comes back to much lower yields. There’s good reason to think 10-years will never return to 1980s levels, so mortgage rates aren’t likely to rise that high either.
Contrary to popular belief, Fed policy does not have much impact on the bond market over the long term (although quantitative easing may be an exception). Most of the time, long-term bond yields are a function of three factors. The principal is simply the supply and demand for bonds. Proponents of mean reversion assumed that demand for bonds was fairly stable, but then it increased – a lot. Governments and foreign investors, seeking to stabilize their currencies and transact in dollars, have developed an insatiable appetite for dollar assets.
Meanwhile, regulations forced financial institutions to hold more bonds. The Fed has also become a big buyer; its new policy playbook is to buy long-lived assets when there is a hiccup in the economy that threatens market liquidity. The Fed may have set an implicit price floor under the stock market, but the last two recessions have clearly shown that there is an explicit floor under bond prices, which makes them more valuable and lowers yields.
The other two factors are related to inflation. If you hold a 10-year bond to maturity, you’ll want to be compensated for the inflation that will occur during that time. We don’t know what inflation will be over the next 10 years, but bondholders bear that risk, so the more unpredictable inflation is, the higher yields rise. When inflation became both much lower and more predictable – as we saw in the decades before the pandemic – bond yields tended to fall.
Whether yields (and mortgages) go up or down or stay the same depends on whether these three factors change again. And there is reason to believe that the 40-year Treasury bull market is over. Governments and foreign investors are losing interest in US Treasuries. Inflation may be permanently higher and more uncertain.
However, all hope is not lost. Fed policy and financial regulations are unlikely to change, supporting demand. So overall, mortgage rates could rise further, but they probably won’t reach 1980s levels unless inflation picks up and holds. Then anything can happen.
All of this suggests that you cannot time the market or the future of interest rates. If you wait for rates to drop, you may be waiting a long time.
More other writers at Bloomberg Opinion:
Ready to buy a house? Wait a few weeks: Conor Sen
Adjustable mortgage rush not the same as 2008: Alexis Leondis
Housing defies Fed campaign to curb inflation: Jonathan Levin
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Allison Schrager is a Bloomberg Opinion columnist covering the economy. A senior fellow at the Manhattan Institute, she is the author of “An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk”.
More stories like this are available at bloomberg.com/opinion