Interest rates and oil

[James]

Originally Posted by flaja The T-bill market is a completely separate entity from the bank loan/mortgage market.

Bond yields are typically used to set mortgage rates.

[flaja]

Originally Posted by James Bond yields are typically used to set mortgage rates.

Then why has the FED been lowering the interest rates it charges when it loans money to member banks in hopes that it can reduce the impact of the current foreclosure mess?

The interest on T-bills is lower than the bond market would otherwise dictate since the income from T-bills is not subject to income taxes. T-bills do not accurately indicate interest rates in the economy as a whole.

[James]

Bond yields are a key benchmark that lenders use to set mortgage rates. Yields on 10-year and 30-year Treasury securities are typically used to set long-term mortgage rates. Short-term loans are pegged to shorter-term Treasury securities.

Indexed Treasury yields provide a direct market reading on the real rate of interest (Source: Poole, William [President, Federal Reserve Bank of St. Louis] "Fed policy to the bond yield” (July 12, 2002). Available at EconPapers: Fed policy to the bond yield).

[flaja]

Originally Posted by James Bond yields are a key benchmark that lenders use to set mortgage rates. Yields on 10-year and 30-year Treasury securities are typically used to set long-term mortgage rates.

Why?

Why aren’t mortgage rates set by market forces, i.e., the more people there are who want mortgages the higher the mortgage rates will be.

Short-term loans are pegged to shorter-term Treasury securities.

Can't you buy some T-bills that mature in less than a year? Do we have mortgages that go for less than a year?

Indexed Treasury yields provide a direct market reading on the real rate of interest (Source: Poole, William [President, Federal Reserve Bank of St. Louis] "Fed policy to the bond yield” (July 12, 2002). Available at EconPapers: Fed policy to the bond yield).

This “real rate of interest” is supposedly what interest rates would be if consumer prices stay the same. In a world where an ever-increasing number of people needs to purchase an ever-decreasing supply of natural resources, inflation is inevitable so investors will always want to earn interest at a rate that is higher than whatever inflation may be in the long run; otherwise their investments lead to an economic loss. Only a fool would want to earn this real rate of interest on his investments because only a fool would believe that there will be no inflation in the future.

BTW: When the federal government wants to spend more money than it collects in taxes it must either print more money or borrow money to make up the difference. During the 1970s the federal government’s policy was to print more money. This naturally causes inflation and is one of the main reasons why the FED’s interest rate policies in the 1970s could not control inflation.

[James]

Originally Posted by flaja Why aren’t mortgage rates set by market forces.

This article explains how mortgage rates are set and the relationship between mortgage rates and bond yields.

The mortgage industry has three primary parts or businesses: the mortgage originator, the aggregator and the investor. The mortgage originator is the lender. Lenders come in several forms, from credit unions and banks to mortgage brokers. Mortgage originators introduce and market loans to consumers. They sell loans. They compete with each other based on the interest rates, fees and service levels that they offer to consumers. The interest rates and fees they charge consumers determine their profit margins. Most mortgage originators do not portfolio loans (they do not retain the loan asset). Instead, they sell the mortgage into the secondary mortgage market. The interest rates that they charge consumers are determined by their profit margins and the price at which they can sell the mortgage into the secondary mortgage market. (For more insight, check out Analyzing A Bank's Financial Statements.) The aggregator buys newly originated mortgages from other institutions. They are part of the secondary mortgage market. Most aggregators are also mortgage originators. Aggregators pool many similar mortgages together to form mortgage-backed securities (MBS) - a process known as securitization. A mortgage-backed security is a bond backed by an underlying pool of mortgages. Mortgage-backed securities are sold to investors. The price at which mortgage-backed securities can be sold to investors determines the price that aggregators will pay for newly originated mortgages from other lenders and the interest rates that they offer to consumers for their own mortgage originations. (To learn more about MBS, see Profit From Mortgage Debt With MBS.) There are many investors in mortgage-backed securities: pension funds, mutual funds, banks, hedge funds, foreign governments, insurance companies, and Freddie Mac and Fannie Mae (government-sponsored enterprises). Since investors try to maximize returns, they frequently run relative value analyses between mortgage-backed securities and other fixed income investments such as corporate bonds. As with all financial securities, investor demand for mortgage-backed securities determines the price they will pay for these securities. Do investors determine mortgage rates? To a large degree, mortgage-backed securities investors determine mortgage rates offered to consumers. As explained above, the mortgage production line ends in the form of a mortgage-backed security purchased by an investor. The free market determines the market clearing prices investors will pay for mortgage-backed securities. These prices feed back through the mortgage industry to determine the interest rates offered to consumers. Fixed Interest Rate Mortgages The interest rate on a fixed-rate mortgage is fixed for the life of the mortgage. However, on average, 30-year fixed-rate mortgages have a lifespan of only about seven years. This is because homeowners frequently move or refinance their mortgages. (To read more about refinancing your mortgage, see The True Economics Of Refinancing A Mortgage and Mortgages: The ABCs Of Refinancing.) Mortgage-backed security prices are highly correlated with the prices of U.S. Treasury bonds. This means the price of a mortgage-backed security backed by 30-year mortgages will move with the price of the U.S. Treasury five-year note or the U.S. Treasury 10-year bond based on a financial principal known as duration. (In practice, a 30-year mortgage's duration is closer to the five-year note, but the market tends to use the 10-year bond as a benchmark.) This also means that the interest rate on 30-year fixed-rate mortgages offered to consumers should move up or down with the yield of the U.S. Treasury 10-year bond. (A bond's yield is a function of its coupon rate and price.) Economic expectations determine the price and yield of U.S. Treasury bonds. A bond's worst enemy is inflation. Inflation erodes the value of future bond payments - both coupon payments and the repayment of principle. Therefore, when inflation is high, or expected to rise, bond prices fall, which means their yields rise. (There is an inverse relationship between a bond's price and its yield.) (To keep reading on inflation, see All About Inflation, Curbing The Effects Of Inflation and The Forgotten Problem Of Inflation.) The Federal Reserve plays a large role in inflation expectations. This is because the bond market's perception of how well the Federal Reserve is controlling inflation through the administration of short-term interest rates determines longer-term interest rates, such as the yield of the U.S. Treasury 10-year bond. In other words, the Federal Reserve sets current short-term interest rates, which the market interprets to determine long-term interest rates such as the yield on the U.S. Treasury 10-year bond. Remember, the interest rates on 30-year mortgages are highly correlated with the yield of the U.S. Treasury 10-year bond. If you're trying to forecast what 30-year fixed-rate mortgage interest rates will do in the future, watch and understand the yield on the U.S. Treasury 10-year bond (or the five-year note), and follow what the market is saying about Federal Reserve monetary policy. (To learn more, see The Federal Reserve and A Farewell To Alan Greenspan.) Adjustable-Rate Mortgages The interest rate on an adjustable rate mortgage might change monthly, every six months or annually, depending on the terms of the mortgage. The interest rate consists of an index value plus a margin. This is known as the fully indexed interest rate. It is usually rounded to one-eighth of a percentage point. The index value is variable, while the margin is fixed for the life of the mortgage. For example, if the current index value is 6.83% and the margin is 3%, rounding to the nearest eighth of a percentage point would make the fully indexed interest rate 9.83%. If the index dropped to 6.1%, the fully indexed interest rate would be 9.1%. The interest rate on an adjustable-rate mortgage is tied to an index. There are several different mortgage indexes used for different adjustable-rate mortgages, each of which is constructed using the interest rates on either a type of actively traded financial security, a type of bank loan or a type of bank deposit. All of the different mortgage indexes are broadly correlated with each other. In other words, they move in the same direction, up or down, as economic conditions change. Most mortgage indexes are considered short-term indexes. "Short-term" or "term" refers to the term of the securities, loans or deposits used to construct the index. Typically, any security, loan or deposit that has a term of one year or less is considered short term. Most short-term interest rates, including those used to construct mortgage indexes, are closely correlated with an interest rate known as the Federal Funds Rate. Forecasting Changes If you're trying to forecast interest rate changes on adjustable rate mortgages, look at the shape of the yield curve. The yield curve represents the yields on U.S. Treasury bonds with maturities from three months to 30 years. When the shape of the curve is flat or downward sloping, it means that the market expects the Federal Reserve to keep short-term interest rates steady or move them lower. When the shape of the curve is upward sloping, the market expects the Federal Reserve to move short-term interest rates higher. The steepness of the curve in either direction is an indication of by how much the market expects the Federal Reserve to raise or lower short-term interest rates. The price of Fed Funds futures is also an indication of market expectations for future short-term interest rates. (Make sure you understand how Fed Fund futures prices are quotes before drawing any conclusions.) Source: How Will Your Mortgage Rate? | Investopedia

[flaja]

Originally Posted by James This article explains how mortgage rates are set and the relationship between mortgage rates and bond yields.

Mortgage originators introduce and market loans to consumers. They sell loans. They compete with each other based on the interest rates, fees and service levels that they offer to consumers. The interest rates and fees they charge consumers determine their profit margins. Most mortgage originators do not portfolio loans (they do not retain the loan asset). Instead, they sell the mortgage into the secondary mortgage market. The interest rates that they charge consumers are determined by their profit margins and the price at which they can sell the mortgage into the secondary mortgage market.

So it is like I said: mortgage rates are set by market forces. If mortgage rates were arbitrarily tied to interest rates that are set by the FED, mortgage originators would not have the flexibility to compete with each other for business.

The aggregator buys newly originated mortgages from other institutions. They are part of the secondary mortgage market. Most aggregators are also mortgage originators. Aggregators pool many similar mortgages together to form mortgage-backed securities (MBS) - a process known as securitization. A mortgage-backed security is a bond backed by an underlying pool of mortgages. Mortgage-backed securities are sold to investors. The price at which mortgage-backed securities can be sold to investors determines the price that aggregators will pay for newly originated mortgages from other lenders and the interest rates that they offer to consumers for their own mortgage originations.

The extent to which mortgage rates are tied to the rates on T-bills or anything else depends on all of the investment rates that the market offers. If you are willing to risk the total loss of your invested money, you can invest in things that carry a high risk while also offering the possibility of high returns. If you don’t want to risk the loss of your investment amount, you will settle for low returns for the sake of having low risk. People that market mortgages in the secondary market must compete with all other investments that the overall investment market has to offer. A mortgage would be a long-term investment, so mortgages naturally have to compete with other long-term investments such as government bonds. This is why mortgage rates are similar to the rates on long-term bonds.

Mortgage rates are not as automatically tied to bond rates as you imply. Market forces (that the FED cannot easily regulate) do have a role.

[James]

Originally Posted by flaja People that market mortgages in the secondary market must compete with all other investments that the overall investment market has to offer. A mortgage would be a long-term investment, so mortgages naturally have to compete with other long-term investments such as government bonds. This is why mortgage rates are similar to the rates on long-term bonds.

Exactly.

Mortgage rates are not as automatically tied to bond rates as you imply. Market forces (that the FED cannot easily regulate) do have a role.

That's correct, but they are highly correlated.

Mortgage-backed security prices are highly correlated with the prices of U.S. Treasury bonds. This means the price of a mortgage-backed security backed by 30-year mortgages will move with the price of the U.S. Treasury five-year note or the U.S. Treasury 10-year bond based on a financial principal known as duration. (In practice, a 30-year mortgage's duration is closer to the five-year note, but the market tends to use the 10-year bond as a benchmark.) This also means that the interest rate on 30-year fixed-rate mortgages offered to consumers should move up or down with the yield of the U.S. Treasury 10-year bond. (A bond's yield is a function of its coupon rate and price.)