What is behind the recent rise in mortgage rates

June 12, 10:42 AMEconomy ExaminerCharles Sherry

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Mortgage rates have surged over the past month, stifling the mini-boom in refinancings and putting Fed Chief Ben Bernanke's plan to kick-start housing in doubt.

A short time ago a 30-year fixed mortgage below 5% was the rule. And the chart (data source from Bankrate) on the right underscores the surprise and shock many have experienced after recently attempting to refinance their mortgage or purchase a home.

This seems especially confusing since the Federal Reserve has kept the fed funds rate below 0.25% since December.

So why the sudden sea change? We must first look at how mortgage rates are set in the marketplace.

Correlation between Treasury bonds and mortgage rates

The rate on a 30-year fixed mortgage is based closely on the yield for the 10-year Treasury bond and has historically run about 1.5 percentage points above what the benchmark bond will fetch. Remember, Treasuries are considered risk free and home loans are not, so a homeowner will pay a higher rate than the government.

Unlike short-term rates such as money markets or T-bills, the Fed has very limited control over longer-term rates.  Some of you may remember former Fed Chairman Alan Greenspan calling the lack of upward movement in rates for longer-term bonds a "conundrum," as the steady and gradual rise in the fed funds rate from 2004-2006 had little impact on the yield curve.

Current Chairman Ben Bernanke is being reminded of how little sway the Fed has over longer-term rates. The announcement in March of additional purchases of mortgage-backed securities totaling $1 trillion and $300 billion in longer-term Treasuries had only a temporary effect on the longer end of the yield curve.

Bernanke did concede last week in his testimony before a House Committee that yields have risen. He cited the looming federal deficit, expectations of an economic recovery, a reversal of flight-to-quality flows, and technical factors related to the hedging of mortgage holdings. I suspect he is right.

I might add one more plausible reason.  Inflation expectations have been rising among bond traders and that has also affected yields.

There is one other factor that comes into play when setting mortgage rates - risk in the marketplace. The ten-year Treasury bottomed just below 2.10% near the start of the year, but mortgage rates held above 5%. At that time, there was a huge premium for risk that was lingering in the system following the Lehman Brothers' fiasco. 

Nervous money had poured out of even relatively safe investments and took shelter in Treasuries. And the economy was shrinking rapidly, adding to the allure of Treasuries. Consequently, a big spread developed in many measures of risk, including the difference between mortgage rates and risk-free government bonds.

Since the beginning of the year, credit markets have thawed considerably, and the spread between home loans and Treasuries is near the historic norm. See Credit markets on the mend.

Predicting where rates may be headed is dicey at best.  I believe the quick run-up in yields may have gotten a little ahead of itself, and Treasury rates have backed off from Wednesday's eight-month high. This should alleviate some pressure on mortgage rates, at least in the short term, as we did see a slight dip yesterday.