March Madness in the Markets: Mortgage Rates Go on Coronavirus Roller-coaster Ride

March madness

This special report illustrates how mortgage rates have responded to coronavirus fears and financial market volatility. It's certainly been a roller-coaster ride!

Part 1: Mortgage Rates Dropped to Historic Levels
Mortgage rates are determined by the supply and demand for mortgage bonds in the bond market. When mortgage bond prices go up, mortgage rates go down. When mortgage bond prices go down, mortgage rates go up. In early March, mortgage bond prices went up dramatically, causing mortgage rates to drop to historic levels. At one point, it was estimated that over $6 trillion in home loans were eligible for a refinance. To put this in perspective, the mortgage industry originated $2 trillion in home loans last year. In a matter of just two weeks, the industry was facing a scenario where it was expected to process in one month, three times the volume it processed in an entire year.

Part 2: Interest Rates Skyrocketed by 0.75% in One Week

Bond investors got spooked when they realized the HUGE amount of bond supply they were expected to absorb in such a short period of time. Not only that, but the new economic stimulus plans are going to increase the supply of Treasuries in the market due to increased government borrowing. This realization caused many bond investors to run for the exits, driving down the demand for mortgage bonds. This caused mortgage rates to spike by nearly 0.75% in one week!

Part 3: The Fed Got Involved
Over the weekend, the Fed announced it would be ramping up its purchase of mortgage bonds. This should have the impact of driving down mortgage rates once again. In fact, the Fed announced the following actions to stabilize the financial markets:
  • $700 billion in bond purchases: The Fed will purchase at least $500 billion of US Treasuries and $200 billion of mortgage bonds over the next few months. Also, when homeowners refinance their mortgages or pay down principal causing mortgage bonds to pay off early, the Fed will reinvest the principal repayments back into the market. This should help keep mortgage rates and other borrowing costs lower in the economy.
  • Short-term rates down to 0%: The Fed lowered the Fed Funds target rate to a range of 0% - 0.25%. This will cause banks to lower their "Prime" rate to 3% or 3.25% (Prime is 3% above the Fed Funds Rate). This will cause rates to go down on home equity lines of credit, business loans, credit cards and other debt tied to the Prime rate.
  • "Easy Money" Policy: The Fed took several other actions to provide liquidity to the financial system such as lowering its bank reserve requirement to 0%. This means that banks are encouraged to loan out their excess funds to consumers and businesses as opposed to keeping their excess funds in reserve. This should make it easier for consumers and businesses to get loans during this difficult time for the economy.

Why Don't Mortgage Rates Follow the 10-yr Treasury?

1 – More risk. The 10-year Treasury is backed by the full faith and credit of the US government. Mortgage bonds are backed by the full faith and credit of American homeowners. If the economy enters into a bad recession, the US government is unlikely to default on its debt. However, if homeowners lose their jobs, they may default on their home loans, causing mortgage bond investors to lose money. Therefore, mortgage bonds carry more risk than US Treasuries. For this reason, when times are tough, the “spread” tends to widen between mortgage bond yields (mortgage rates) and US Treasury yields.

2 – Pre-payment Risk. If mortgage rates drop, this causes homeowners to refinance their mortgages. When that happens, mortgage bond investors are forced to trade in their higher-yielding mortgage bonds for lower-yielding mortgage bonds. Plus, the investors lose money if they paid a premium for the higher-yielding bonds when they initially bought them. For this reason, mortgage bonds tend to react slower to a declining rate environment vs. US Treasuries.

What's Next? Buckle your seatbelt and get ready for more madness in the financial markets this week! Expect continued volatility as the financial markets process the economic impact of the coronavirus. Please contact me for more info or if you have any questions.