Treasury Rates Tumbled, but Don’t Wait for Mortgage Rates to Match their Decline

The relationship between the 30-year fixed rate mortgage and the 10-year Treasury Bond appears to be weakening.

Palm Coast, FL – August 22, 2011 – It is widely believed that the rate on the 30-year fixed rate mortgage tracks the 10-year Treasury bond.  This is true, but during certain episodes the relationship between the two rates appears to weaken, which leads some to suspect that the two have become unhinged.  In fact, rational market dynamics are at work.

The 30-year fixed rate mortgage is based on the 10-year Treasury because the typical homeowner lives in their home for 8 to 10 years.  There is an additional margin to the 30-year mortgage rate that compensates mortgage backed securities (MBS) investors for the perceived risk that it carries relative to the 10-year Treasury, which is regarded as the closest thing to a risk-free asset in the financial markets.  This spread has averaged about 1.75% over the last 30 years and 1.5% over the last decade.

However, when the Treasury rate falls, especially if the decline is rapid and sharp, the 30-year FRM seems to have trouble keeping up.  The reason for its sluggishness is that MBS investors face a greater risk of homeowners refinancing as rates plunge.  When homeowners refinance, MBS investors must reshuffle their investments and incur costs in doing so.  Consequently, when rates dive, MBS investors will shift to purchases of 10-year Treasuries, which won’t be refinanced.  The MBS investors are trading a lower return in exchange for safety.  Note that the effect on the spread between the Treasury and the 30-year FRM is amplified since the MBS investors are withdrawing their demand from the one asset and putting it into the other.

Source: National Association of Realtors®