Happy Fall, it is hard to beat this time of year with snow up top and changing leaves in the valleys (do you know where I took this pic?) Yields for U.S. government debt posted the biggest weekly jump in months on Friday, as a selloff in bonds that commenced in late September proceeded despite a weaker-than-expected employment report for September. What happened in the recent jobs report? Why have interest rates risen sharply? How much higher will they go? What does this mean for real estate?
What was in the September jobs report
When the September jobs report came in there was initially a bit of disappointment as the number of jobs was considerably less than predicted. Here are a few highlights:
- Average hourly earnings rose 0.6% in September and was up 4.6% year over year.
- Nonfarm payrolls increased by 194,000 in September, compared with the Dow Jones estimate for 500,000.
- The unemployment rate dropped to 4.8%, better than the expected 5.1%.
- Leisure and hospitality along with professional and business services and retail led job creation.
How are mortgage rates “set”?
First, it is important to note that the federal reserve does not directly control mortgage rates. The fed controls the “federal funds rate”. The federal funds rate is the rate at which banks and credit unions lend reserve balances to other banks and credit unions overnight. In a nutshell this is the rate banks get on the money they are holding in cash/reserves. Here is a more detailed explanation from Wikipedia .
So how are mortgage rates set? Unfortunately, mortgage rates are not “set”. There is no government or private party that can set rates per se. Mortgage rates are based on the 10-year treasury yield. So how does this work?
Before discussing rates, it is important to understand how bond yields work. The most important piece of this equation is the relationship between a bond price and its return. For treasuries, it is critical to note that a bond price and its yield move in inverse. What this means is that a higher bond price results in a lower yield and vice versa where a higher yield results in a lower bond price. For simplification purposes, I will not get into the full details of why bonds function the way that they do. Rest assured that it works this way and will always work this way.
With this key piece of information, we can now understand why mortgages do not move in direct correlation with the federal funds rate. This is now very apparent as the federal reserve has pledged low rates and yet the 10 year treasury just reached its highest level in over a year.
Why are treasury yields and in turn mortgage rates rising now?
Long and short, the “market” is not believing the federal reserve that inflation will stay at historic lows and there is worry about the supply of bonds coming on the market from the recent 1.9 trillion stimulus coupled with talks of even more government spending.
- Actual Inflation: With wages rising, rents rising, and most raw materials rising it is no surprise that prices are going up. Prices are increasing from food, rent, transportation, vacations, computers, etc.… Essentially most items consumers buy have increased in price. The recent huge gain in the jobs report reiterates the pricing pressures and how far the recovery has come.
- Inflation expectations: Market expectations for S. inflation rates have reached their highest levels in a decade, driven by a large fiscal package, progress on vaccine rollouts and pent-up consumer demand. The pent-up demand seems poised to raise prices while at the same time supply has become constrained on items like semiconductors. These two factors are driving treasury rates higher.
- Supply of bonds: The supply of bonds is getting allot less attention than inflation expectations but is even more important that inflation expectations. With the various stimulus bills enacted, the federal government is forced to sell trillions of dollars in new bonds to finance all these items. A good way to understand this is to think of a car lot, if you are going to buy a new car and there are three hundred on the lot, your chance of getting a better deal is greatly increased due to the supply. The same for bonds, as more bonds hit the market, the prices will decrease. Remember yields work in inverse to price so as prices decrease the yields will increase which in turn leads to higher rates.
Mortgage rates have risen sharply what does this mean for real estate?
When I was writing this article rates on a 30 year conventional mortgage were hovering around 3.5%, this is up from a low of around 2.75%. This is a 30% increase from the bottom of rates. The market average prediction is that the 10 year treasury will rise to 2% by year end. This would likely bring 30 year mortgage rates closer to 4%.
Although 4% is still an excellent rate compared to historical averages, it is substantially higher than the 2.75% that we saw just a few months ago. With the large increases in rates while at the same time properties have increased in value will lead to heartburn in the real estate market.
Let’s take for example Denver, in Denver, residential real estate prices have increased approximately 40% in the last 3 years, this has driven the average home price to $725,000. As rates have risen, Denver residential sales have fallen and values have dropped about 5% off their highs. This same trend will occur first in expensive market but ultimately spread to lower priced markets as houses become relatively more expensive due to higher interest rates.
Will interest rates on mortgages continue to rise in 2021?
Absolutely. Demand looks to continue which will spur inflation expectations while at the same time a firehouse full of bonds will be crushing the market forcing prices and in turn yields to increase. Treasuries have been on an upward march lately and this trend looks to continue and accelerate over the year.
Goldman Sachs, BofA Global Research and BlackRock are among firms that have said yields will rise to near 2% by year-end — an outcome that could be hastened if a strong economy pushes the Federal Reserve to begin unwinding its ultra-easy monetary policies sooner than expected.
“We think the recovery in long-dated Treasury yields that has taken place over the past week or so is a sign of things to come,” analysts at Capital Economics said in a note published Friday. “We suspect that growth in the US will be quite strong in the coming quarters, and that the recent surge in inflation there will prove far more persistent than most anticipate,” the firm said.
The recent jobs report highlights increased labor costs for businesses and also a recovering economy. These two items will force the federal reserve to step away from the easy monetary policy which in turn is driving rates higher. Furthermore, inflation is proving substantially less transitory than predicted which will likely lead to a faster pace at the Federal reserve to slow future inflation. All of this adds up to higher rates. Mortgages have already jumped 40% with predictions of the 30 year topping 4% by year end. In expensive markets like Denver we are already seeing the effects with slowing sales prices and small declines in values. Look for real estate to soften the rest of 2021 with higher rates and 2022 could be even more interesting if inflation continues untamed. The recent jump in treasuries should serve as a warning that the days of double digit appreciation are in the rear view mirror.
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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 Bloomberg, Businessweek ,the Colorado Real Estate Journal, National Association of Realtors Magazine, The Real Deal real estate news, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
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