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We’ve recently watched the federal reserve raising short term interest rates while the 10-year treasury barely moved.  Inflation expectations are low, but suddenly 10-year treasuries began moving drastically higher climbing to a 10-month high and mortgage rates also jumped.   Why the sudden change when inflation expectations have barely changed?  What does China have to do with recent move in U.S. mortgage rates?

First, it is important to emphasize that the federal reserve does not control interest rates.  They merely influence short term rates based on the federal funds rates.  Long term rates (10-year treasuries) are market driven.

There are two drivers of long term rates: Inflation expectations and Market Forces:

  1. Inflation Expectations: One of the major drivers Treasury pricing is driven by future expectations on inflation.  Is the economy going to grow and are prices going to rise?  As inflation increases, the yields on treasuries also increase.  Currently there is some talk of future inflation, but it has been muted by low commodity prices and labor costs that continue to stagnate.  This leads us to Market Forces as the primary driver today of the treasury market and in turn long term interest rates.

 

  1. Market Forces: This refers to basic supply and demand.   Demand is driven by investors in the US along with many investors and countries abroad that park their money in US treasuries due to the safety and liquidity.  The largest demand is from international investors like China.  The large demand for treasuries has increased prices and therefore kept yields (rates) at historic lows.  On the flip side is supply.   The more supply of treasuries, the lower the price and the higher the yield (remember they move in opposite directions).  The borrowing needs of the US will continue to grow with deficit spending.  The non-partisan congressional office (CBO) has confirmed this as well with deficits predicted to swell in the coming years

 

  1. Supply: The supply of treasuries will continue growing rapidly as the government continues deficit spending and reducing their balance sheet of assets that were purchased in the last recession. The U.S. posted its largest budget deficit since 2013 in the fiscal year that just ended on Sept. 30, and most economists predict that President Donald Trump’s tax-reform plan will worsen deficits. The bigger budget shortfalls they foresee would add to the more than $10 trillion-plus rise in federal debt over the next decade that the Congressional Budget Office is already forecasting.” Treasury issuance would continue to rise as the budget shortfall increases.  In a nutshell, supply will continue to increase which will drive prices down and yields up
  2. Demand: According to a recent Bloomberg article “Senior government officials in Beijing reviewing the nation’s foreign-exchange holdings have recommended slowing or halting purchases of U.S. Treasuries, according to people familiar with the matter.” China is the largest buyer of U.S. Treasuries and therefore any major pullback from purchases will drop the demand of U.S. Treasuries.  From economics 101, a drop in demand usually means prices will come down as well.  This will lead to higher yields and ultimately higher interest rates.

 

 

What does China have to do with anything?  China is the largest buyer/holder of U.S. Treasuries with an estimated 1.15 trillion.  This gives China the ability to “influence” treasury prices.  For example, if all the sudden China started divesting treasuries this would push the price down and yields up.  There is speculation that China is selling treasuries now due to the “trade spat” with the current administration.  This influence by China and other entities will only get worse as deficits increase.

How does the tax plan influence rates?  According to the Congressional Budget Office, deficits will continue to grow due to the recent tax plan and increased costs of entitlement programs (Social Security, Medicare, Medicaid, etc…).  As supply of treasuries increase rates will need to continue to increase as well as purchasers will require higher rates of return.

 

What are the long-term impacts on rates/mortgages? A sharp increase in long term rates is not good for the economy.  Longer term treasuries are the primary driver of both commercial and residential mortgages along with other longer-term securities.  The recent increase in rates will slow down purchases and refinances on the commercial and residential side.

 

The economy could be in for a wild ride.  It doesn’t look like the deficit is going to do anything other than grow larger in the future.  This reliance on deficit spending makes the U.S. economy more prone to spikes in rates as we are seeing today.  The large deficit also increases our reliance on other countries/investors to continue to finance our budget.   This opens the door for countries like China to have an active say in the U.S. economy by either buying or selling treasuries to manipulate interest rates for their own gains.  Are you ready for your residential and commercial mortgage rates to be controlled by a foreign country?

 

Sources/Additional Reading

  1. https://www.bloomberg.com/news/articles/2018-01-10/china-officials-are-said-to-view-treasuries-as-less-attractive
  2. https://www.bloomberg.com/news/articles/2018-01-09/u-s-10-year-yield-climbs-as-boj-action-spurs-exit-speculation
  3. https://www.bloomberg.com/news/articles/2017-11-01/treasury-to-keep-borrowing-at-62-billion-for-seventh-quarter
  4. https://www.cbo.gov/publication/52370
  5. http://money.cnn.com/2017/08/16/investing/china-us-debt-treasuries/index.html

 

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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending.  Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in the Colorado Real Estate Journal, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.

 

Fairview is a hard money lender specializing in private money loans / non-bank real estate loans in Georgia, Colorado, Illinois, and Florida. They are recognized in the industry as the leader in hard money lending with no upfront fees or any other games. Learn more about Hard Money Lending through our free Hard Money Guide.  To get started on a loan all they need is their simple one page application (no upfront fees or other games).