After falling to historic lows of less than 5%, then suddenly spiking dramatically higher to almost 6%, mortgage rates have drifted down by about 1/2 percent. Here in the Chicagoland area they have been stuck in a range roughly between 5.125% and 5.625%, of course depend on factors like the borrower’s FICO score and the Loan to Value ratio of the deal. The market forces that determine what interest rates will be are engaged in a tug of war or sorts, with the result so far being a standstill.

We have the following market forces that are pushing rates higher:

1) The US Dollar falling in value against other major currencies.

Since Bonds are denominated in US Dollars, the true yield must be adjusted lower since the investors Bonds will be worth less if the Dollar is worth less than when they made their purchase. Therefore investors demand a higher rate of return on their bond purchases.

2) Anticipation of an increase in the rate of Inflation.

A higher rate of inflation makes the Dollar worth less, so as in the example above, a Bond investor will demand a higher rate of return to compensate for this lower real return due to inflation. We should note that at this point, we are only talking about anticipation or expectations due to the increase in the money supply. The actual inflation rate is quite low. According to the Bureau of Labor Statistics the CPI increased at a seasonally adjusted rate of 0.1 percent in May, at 0.0 percent or unchanged in April, and the index has fallen 1.3 percent over the last 12 months.

The economy is not nearly strong enough to create demand-pull inflation, and with high unemployment I cannot see the basis for cost-push inflation either. I think that the inflation fear mongers can be ignored for now. Given the Trilions of dollars of wealth that were destroyed in the crash of October 2008, much of an increase in the money supply will simply be sopped up in a system where banks must now deleverage to strengthen their balance sheets.

We have the following market forces that are pushing rates lower:

1) Strong demand for Bonds.

When the stock market crashed, many investors took what they had left and put it in safe havens like Bonds. The Fed’s strategic purchases of Treasuries has also kept demand strong, albeit at somewhat higher yields.

2) A Shrinking TED Spread.

The TED Spread is a commonly accepted measure of investors appetite for risk. A higher spread means investors demand higher rates to compensate for this perceived higher risk. A lower spread means investors are clam enough to accept a lower rate of return. The spread hit a high of 463 in October 2008. It is now at 42.

I like Investopedia’s explanation of the TED Spread so much I’ll quote them here - “The Ted spread can be used as an indicator of credit risk. This is because U.S. T-bills are considered risk free while the rate associated with the Eurodollar futures is thought to reflect the credit ratings of corporate borrowers. As the Ted spread increases, default risk is considered to be increasing, and investors will have a preference for safe investments. As the spread decreases, the default risk is considered to be decreasing.”*
* http://www.investopedia.com/terms/t/tedspread.asp

Although I believe that inflation fears are overblown, the dollar will likely remain weak until we see strong and consistent signs of an economic recovery. The catch-22 problem is, once we do, the stronger economy will create a a stronger demand for money, which will start to push up rates. The bottom line is that given the aforementioned circumstances rates are much more likely to go higher than lower. 5% - 5.25% appears to be a pretty solid floor for the foreseeable future.

Mortgage interest rates are falling again after rising to hit almost 6% last week. Rates for mortgage loans are now in a range between 5.375% and 5.75%. Currently market pressures show this downward trend continuing in the short term. Money is moving out of the stock market, and foreign countries such as Russia have not only stopped saying unflattering things about the US dollar, but have actually been affirming its importance as the world reserve currency. This helps strengthen the dollar and results in money also flowing out of commodities, with some of it going into bonds.

The Fed has the balancing act to maintain between working to promote full employment and working to keep inflation low. The financial publications, such as CNBC, report that the Fed may extend their purchases of U.S. Treasuries when they meet next week. This will help to stimulate the economy with added liquidity, but due to investors inflation concerns an overly aggressive expansion of buying is not likely.

The steep rise in U.S. government bond yields resulted in the latest spike in mortgage rates. Rising interest rates while still in the depths of a severe recession would slow down or stall economic recovery efforts. Fortunately other measures of credit market unease, like the spread between U.S. government debt and recent corporate debt issues, have eased. This helps the Fed a lot with its delicate balancing act. They do not have to feel compelled to risk furthering inflation fears buy buying U.S. Treasuries too aggressively.

Given current and historical trends, it is likely that we saw an historic low in mortgage interest rates last month, when they were as low as 4.5% to 4.625%. Since I do not have a crystal ball, and no one can pick market tops or bottoms with absolute accuracy, I’d advise those looking to purchase or refinance a home to lock into any rate near 5%. If we see anything around 5.125% to 5.375% I’d say lock and load!

Some of these long term trends are easy to see. The forces at work are powerful and inevitable. At some point those buying our bonds will worry that the value of their investment will decrease due to either a drop in the value of the dollar, or to inflation, or simply to reduced demand. Since the value of the dollar is relative to other currencies, and most of the other major currencies are not doing so well because their economies are also struggling, that would not account for the increase in rates. Inflation is not yet a problem, so that would not cause rates to rise either. However, there are many people who anticipate inflation will increase, and some think it will be sooner rather than later and are moving money into commodities like Gold and Oil. Some of that money must be moving out of bonds. Also, the stock market has been doing well as of late, with money moving into stocks as well.

The Fed has also slowed the rate at which it has been buying up Treasuries, further reducing demand. The Fed cannot continue to buy up Treasuries forever, since to overdo it would stoke up inflation. Remember, when the Government buys bonds from itself, it does so through what is alternately called monetization or quantitative easing. Laymen would call it printing money.

You just do not know exactly when these things will play out. Mortgage Rates have been slowing trending up, but they really spiked up in the last two days. Even before this event, mortgage applications dropped 8.6% last week according to the Mortgage Broker’s Association survey released Wednesday. I don’t understand why. Not only were rates as low as most adults have ever seen, a trending up would lead many homeowners to say “hey, I better lock into these good rates while I can.” I have been emphasizing the fact that rates have been at historic lows not seen in the 38 years that Freddie Mac has been tracking mortgage rates.

I have been surprised at how many people have not understood the significance of this enough to act on it, especially with the expanded loan approval guidelines recently instituted by the Obama Administration allowing for creditworthy homeowners to borrow up to 105% of their home values to refinance down to lower rates. Is this something that is too abstract for someone outside of the industry, or someone who does not have a “head for numbers,” to grasp based on that statement alone? I have even worked the numbers for some people, showing them how they would save $200 to $300 per month, EVERY MONTH, by refinancing at these incredible rates. I’m talking about middle class people, so that’s a significant, recurring savings. In some cases it seemed like I was just talking to myself.

I do have to give one of my customers credit. This guy also happens to be a friend, and a former statistical engineer. He asked me to work up a refinance of his home a few weeks ago. I wrote up the deal, and monitored the rates. I locked him in under 5% with no points. We happened to time the bottom almost exactly. He obviously had a firm grasp of the historical significance of where the rates were at the time, apparently because he has a head for numbers.

It is said that a picture is worth a thousand words. With that in mind, I have prepared some charts based on this historic mortgage rate data. Since 38 years is a long time, one chart was way too wide, so I broke it up into four charts, one for each decade. The 1970s data for rates begins in April 1971, and for points begins in May 1971. The data ends in April 2009. To view the Historic Mortgage Rate Charts, Click the image below

Use the arrows to move through the four decades of data, double-click to zoom in or out. Hit the escape key to exit full screen.

Neither rates nor stock prices usually go straight up or straight down. The charts are not straight lines, they wiggle as they trend in a certain direction, with peaks and dips. There was strong demand in the auction of 7-year Treasury notes yesterday, and pressure on the Fed to keep buying Treasuries to keep rates low to help the economy in general and the housing market in particular. With that in mind I am looking for one of those dips to lock in my current customers at the best rate I can.