Lower interest rates: a worst-case scenario? The reality of quantitative easing
Why We’re Not Hoping For More Record Mortgage Rates
On March 15, 2020, the Federal Reserve shocked the United States by cutting interest rates by one point and unveiling a $700 billion stimulus package.
Earlier we wrote about how Fed rate cuts don’t always lead to lower mortgage rates.
But the Fed’s new measure to combat COVID-19 — a $700 billion quantitative easing program — could have a much bigger impact for borrowers.
The last time mortgage rates hit record lows (apart from a short stint this year) was in 2012. Right in the middle of a huge QE stimulus package to help the US out of its recession.
The same thing could very well happen again. With the Fed pumping money into the mortgage market, rates could fall back to lows of 3 or even 2.
But should borrowers hope for new record rates? More Fed stimulus could only be the product of prolonged impacts from the coronavirus
In other words, a new high for mortgage rates could be the worst-case scenario. We explain it here.
What is quantitative easing?
Quantitative easing (QE) is “the introduction of new money into the money supply by a central bank”. In the case of the Federal Reserve, that means buying debt in the US market. This injects more money into the economy and helps keep borrowing costs low.
QE aims to stimulate consumer spending when the economy slows.
While COVID-19 has brought huge sectors of the US economy to a screeching halt, the Fed is hoping quantitative easing will help increase stability until things return to a more normal state.
As a huge spender, the Fed can step in to influence prices, as well as yields and mortgage rates. With its current package, the Fed plans to spend $700 billion buying bonds and securities in the markets.
For those watching mortgage rates, it is important to note that 200 billion dollars of this $700 billion package is reserved for the purchase of mortgage-backed securities (MBS).
Quantitative easing, MBS and your mortgage rate
Mortgage-backed securities (MBS) are the economic drivers of mortgage rates. In short, MBS represent the prices that investors are willing to pay for mortgages.
More money flowing into MBS leads to lower rates for borrowers (this is basic supply and demand). This is exactly what the Fed is aiming for with its $200 billion injection of QE into the mortgage market.
Image: Mortgage rates fell through three periods of QE from 2009 to 2013, ending with historic lows at the end of 2012.
With all the fuss they make when you apply, you would think mortgage lenders are investing their own money. But this is rarely the case. Typically, they sell your debt as soon as they can after closing.
What they do is include your mortgage in a whole pile of similar mortgages and sell them all on a “secondary market”. A secondary market is a market that was once separate from the consumer market: it is made up of investors who buy consumer mortgage debt in the hope of earning interest.
Each pool of mortgages is a “mortgage-backed security”.
Lenders are keeping tabs on investor demand for MBS. And they set your mortgage rate based on how much they think those investors will pay for the privilege of holding your loan.
>> Related: Here’s what really determines your mortgage rate
Investors are generally happy to buy MBS because all those mortgage payments from qualified borrowers provide a relatively secure income stream for years to come.
Of course, investors know that few 30-year loans last three decades. But they rely on them to provide flow for a reasonable amount of time. And they’re willing to shell out for those returns – usually.
The coronavirus has turned the system upside down
The secondary market generally does its part to keep mortgage rates low. The greater the demand from investors, the lower the rates for consumers.
But things came crashing down in the first half of March 2020. It started so well: Mortgage rates fell to record lows. But it had an unwanted byproduct.
A tsunami of new applications, particularly for refinancing, frightened investors.
Investors buy MBS because they want a nice, safe and stable income. But if homeowners suddenly start refinancing en masse — maybe only months or a year or two after the last time — that nice, secure, stable income evaporates.
Investors therefore voted with their feet. They would not continue to buy MBS with low yields (due to low mortgage rates) when they risked cutting profits or even losing out on existing bundles due to excessive refinancing.
If they were destined for a low yield anyway, why not buy ultra-safe US Treasuries? After all, unlike landlords, the US government never refinances and (until now!) never defaults, even during recessions and depressions.
Either way, due to investor annoyance, mortgage rates had one of their worst weeks at the end of Friday March 13th (for good reason).
Will quantitative easing bring mortgage rates back to historic lows?
Mortgage rates fell again the following Monday (March 16), almost exactly mirroring the disastrous rise of the previous Friday.
Part of that may be because MBS investors felt the previous week’s hikes had deterred so many refinancers that it was safe to go back into the water.
But much of it was likely due to the promised Fed intervention.
The MBS market is like any other: if a new buyer with $200 billion in their pocket wants to buy what’s on offer, that extra demand will drive prices up as buyers compete for a limited supply.
However, when it comes to bonds, higher prices automatically and invariably mean lower yields – and, for MBS, lower mortgage rates.
Yes, it may be counter-intuitive. But it is a fact. If you want a fuller explanation, there’s one near the back of every edition of The Mortgage Reports.”Mortgage rates today” updates.
And the whole point of the Fed’s current QE program is to stimulate a struggling economy by encouraging consumers and businesses to borrow and spend.
Its intention is therefore to lower all rates, including those for mortgages.
Mortgage rates and QE – we’ve been here before
The Fed’s attempt to lower consumer mortgage rates via QE may well succeed.
Do you remember the last time (before March 2020) that mortgage rates hit an all-time low?
It was towards the end of 2012, and the economy was still struggling to recover from the financial downturn of 2008.
More importantly, the Fed was conducting its third round of quantitative easing, QE3. That ended in 2013, and so did those record mortgage rates.
You probably see a pattern here. The Fed’s QE programs can do good things for mortgage rates.
But let us remember the words of the late Harvard economics professor, John Kenneth Galbraith, who said:
“The only function of economic forecasts is to make astrology respectable.”
Anyone who tells you they know what’s going to happen to the economy is lying.
It is true that some have better forecasting records than others. But many of them would recognize the luck involved in their predictions. So read on with a generous pinch of salt.
Are mortgage rates within 2s possible?
We started by wondering if it was possible that many mortgage rates would soon start with a “2”.
And the answer is an unequivocal yes.
Really, it would be a brave forecaster to deny the possibility of them possibly starting with a “1”, a zero or even a negative symbol.
But we are having issues when trying to update the question from If it’s possible for what is the probability.
You can easily imagine scenarios in which a “2” or a “1” would occur. And such predictions are much less known than they would have been a few months ago.
But the uncomfortable reality of encouragement to lower mortgage rates is that they usually only happen when the economy is struggling. And the lower the rates, the deeper the problems.
Looking at COVID-19 in the long term: Lower rates could be the worst-case scenario
Maybe the Covid-19 coronavirus will miraculously disappear when warmer weather arrives. It happened with the flu virus of 1918. But it came back the following fall even worse than before. And few scientists think we will have a tested and approved vaccine then.
It is likely to bring unprecedented human and economic costs to the lives of many people.
We don’t say this to scare you, but simply because it’s important to recognize the magnitude of the problem and its potential solutions.
The Fed could end up buying more MBS and taking its own rates into negative territory. And that, coupled with investors increasingly desperate to find safe havens for their money, could easily push mortgage rates to previously unthinkable levels.
But the same circumstances would also put many people in a position where they cannot take advantage of lower mortgage rates, through temporary or permanent layoffs.
Let’s face it: most of us would rather have a 5% rate and a job than a 2% rate and an unemployment check.
So if you’re expecting lower rates — or wondering whether to buy or refinance at all, given your projected job security — seriously consider the long-term impacts of this virus.
A lower rate environment could benefit some. But others might benefit more from the lockdown sooner rather than later – or even waiting for it all to be over.
The information contained on The Mortgage Reports website is provided for informational purposes only and does not constitute advertising for products offered by Full Beaker. The views and opinions expressed herein are those of the author and do not reflect the policy or position of Full Beaker, its officers, parent company or affiliates.