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Mortgage Refi Activity Is Driving Rates Higher

Posted by Larry Doyle on May 26, 2009 7:17 PM |

In Wall Street terms, the wheels are coming off the Treasury bus. What does that mean in layman’s terms? Interest rates on U.S. Treasury securities are ratcheting higher. Why? I have addressed the massive supply of global government bonds that will be issued in order to finance the exploding deficits. For newer readers, you can find my thoughts on this topic in Is The Government Bond Bubble Getting Ready To Burst? UPDATE #2.

The dynamics of the massive supply of bond issuance to fund global deficits will not change. To wit, our market needs to absorb $60 billion in 5yr and 7yr notes tomorrow and Thursday.  Long term interest rates in our U.S. Treasury market moved higher by another 10 basis points again today to a level of 3.55%.

Over and above that, though, there is another significant reason that is driving our bond market lower and interest rates higher. This reason is receiving little to no attention by the media or market analysts. In fact, the color allocated to this factor is strictly viewed as a positive. I am talking about the waves of mortgage refinancing precipitated by the Federal Reserve’s quantitative easing program. 

How could refinancing activity further pressure the government bond market driving interest rates higher? Well, let’s accept the premise that any government program is never risk free or cost free. The quantitative easing employed by the Federal Reserve to purchase government and mortgage-backed securities has very real costs. The extraordinary volume of purchases of newly issued mortgage-backed securities by the Federal Reserve has allowed millions of homeowners to lower their mortgage payments. This is great for those benefitting. What are the costs?

The securities backed by these newly issued mortgages have very long durations.  This technical term measures the sensitivity of a bond’s price to a shift in interest rates.  One also needs to understand the nature of a mortgage security. Mortgages in the United States are issued with an embedded refinancing option. The homeowner has the ability to exercise that option whenever he chooses. As interest rates move higher, the likelihood of the homeowner exercising the option to refinance lessens. As such, the duration of the security extends (the security becomes a longer security).

The enormous volumes of newly issued mortgages that have entered the market via the Fed induced refinancing program equates to an equally enormous amount of long duration assets entering the market. These long duration mortgages replace mortgages which had higher rates and shorter durations or adjustable rate mortgages also with shorter durations.

The total bond market index represents a balanced cross section of all the types of bonds weighted by volume. As the new long duration mortgages enter the market, the duration of the index has extended.

Money managers and asset managers who run bond money measured by performance relative to the index have needed to sell assets as the duration of the index has extended. 

Thus, in a self-fulfilling fashion, the issuance of these newly refinanced mortgages has actually caused a lot of selling on behalf of bond managers. In turn, as the market has gone lower (higher rates) the duration of the mortgages and in turn the index further extends causing even more selling. The process is actually circuitous–selling begets more selling.  

Thus, while market analysts, media mavens, and government officials may present the Fed’s program to drive refinancing activity as without cost, they are wrong. The cost is embedded in the long duration of the mortgages which drives interest rates higher across the market as a whole. 

There’s no free lunch!!


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