|
4 October 2001, Revised 11 November
2004, Revised February 22, 2005
"Do declining bond prices cause interest rates to rise?"
No, declining bond prices are
higher interest rates.
Suppose on Monday the US Government
sells a one-year note at 5%, meaning that an investor purchasing a bond today
for $1,000,000 would receive $1,050,000 at the end of the year. Lets
suppose further that moments after the sale of these notes is completed, the
Government announces that because it's deficit is much larger than expected, it
will need to raise much more money than it had previously thought. When it
enters the market on Tuesday, therefore, it must pay 10% on the otherwise
identical note.
Since investors can now earn 10% on
the Tuesday note, the price of the Monday note must fall enough so that
investors earn 10% on that one as well. This forces the price down to
$954,545.
The interest rate on the Monday note
when it was sold was 1,050,000 divided by 1,000,000, minus 1, or .05. The
interest rate on Tuesday was 1,050,000 divided by 954,545, minus 1, or
.10. The decline in price and rise in rate are the same thing.
�Why are mortgage
interest rates
today much lower than in the early 1980s?"
The
major reason is the taming of inflation.
Economists
distinguish between the �nominal� rate of interest and the �real� rate. The nominal rate is the one that is quoted. The real rate is the nominal rate adjusted for inflation. Lenders are concerned primarily with the real rate.
Suppose
a lender is willing to lend $100 for a year if he gets back $106.
That�s a nominal rate of 6%, and if there is no inflation over the
year, the real rate is also 6%. This means that the lender who could buy 100 widgets at the
beginning of the year at $1 a widget, could buy 106 at the end.
But
suppose lenders expect the price of widgets to rise by 5% over the year. Then at 6% the $106 the lender will have at year-end would buy barely 101
widgets. To maintain a real rate of
6%, the lender must raise the nominal rate by 5% to offset the declining value
of principal, and by .3% to offset the declining value of the interest. The
adjusted nominal rate is thus 11.3%. With $111.30 at the end of the year, the lender can buy 106 widgets at
$1.05 a widget.
�In Surinam, mortgage
interest rates
are 36% or
more. Why are rates so much higher
in some countries than in others?�
I
have already discussed the most important reason. Rates were as high as they were in Surinam because the
inflation rate there was high. Countries
with high inflation rates have high interest rates.
A
second factor that affects mortgage rate differences between countries is the
efficiency of the housing finance system. n
most respects, the US system is more efficient than those in most other
countries. As a result, mortgage
rates to prime borrowers in the US are only 1-1.5% above long-term Government
bond yields. In many other
countries, the spread is twice as large or more.
�The
Fed recently dropped rates by 1/2%, but nothing happened to mortgage
interest rates. Doesn�t the Fed control
mortgage rates?�
Your
sense that nothing happened is based on the stability of mortgage rates after
the Fed action. But since the
market anticipated this action, whatever impact it had on mortgage rates
occurred before the action.
Nonetheless,
the impact could have been small because the Fed does not control mortgage
rates. The Fed controls the Federal
Funds rate at which banks lend to each other overnight, and the discount rate
at which Federal Reserve Banks lend to commercial banks for very short periods.
While
short-term rates and long-term rates are related, the relationship is loose. It is not unusual that a large change in short-term rates is accompanied
by a much smaller change in long-term rates. Indeed, because short-term rates are much more volatile than long-term
rates, this is more the rule than the exception.
�What
interest rates do I look at to best predict the direction mortgage interest rates will
take?�
Before
the development of secondary mortgage markets, there was an answer to this
question. Changes in mortgage rates
lagged changes in corporate bond yields by anywhere from 2 to 8 months.
Today,
however, the mortgage market is so thoroughly integrated into the broader
capital market that there are no leading indicators of mortgage rates. Mortgage
rates and bond yields change together.
A
large proportion of all mortgages are placed in pools against which
mortgage-backed securities (MBSs) are issued.
MBSs trade actively in the market and are considered close substitutes
for bonds. Any change in bond
yields, therefore, is transmitted instantly to the MBS market.
Mortgage
loan originators, in turn, base their rates primarily on yields in the MBS
market. Originators usually post
their rates at about 11am EST, after they see the opening yields on MBSs that
morning.
Copyright
Jack Guttentag 2005
| 
