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US Bond Market Warning: Mortgage Rate Impact on Housing Market

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US Bond Market Warning: Mortgage Rate Impact on Housing Market
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The US bond market is flashing warning signs of a possible major breakdown ahead, which could send mortgage rates spiking to levels not seen since 2000. 

The benchmark 10-year Treasury yield surged this year, recently topping 3% for the first time since 2018. This key long-term bond yield acts as a barometer for mortgage rates. As it rises, lenders hiked up rates on new home loans.

Rising 10-Year Treasury Yields the Looming Threat to Mortgage Rates

When people who invest money expect prices for things to go up a lot (inflation), they look at something called “10-year Treasury notes” to see what might happen. These notes are like promises from the government to pay back the money with interest after 10 years.

The cost of things went up by 8.5%, in July, the biggest increase in 40 years. The cause of this is that the government and the main bank provided the people with more money during the pandemic.

The federal reserve took this action after price levels rose. They made borrowing money more expensive by increasing interest rates (the federal funds rate). This was their strategy to slow down how quickly prices were going up.

Market predictions indicate the Fed will likely continue rapidly raising its benchmark rate at upcoming meetings. 

Given the Fed’s recent policy tightening, which has lifted rates by 525 basis points since spring 2022, 10-year Treasury yields have spiked as investors demand higher rates to counter inflation. With inflation still high, the Fed must keep taking strong action by aggressively hiking rates, which will maintain pressure on 10-year yields.

This has already pushed up mortgage rates dramatically. The average 30-year fixed rate recently hit 5.5%, more than double the record lows seen during the pandemic. But some analysts warn the bond rout may just be getting started.

A disastrous selloff in the British bond market recently gave a taste of what a full-on breakdown could look like. UK bond yields skyrocketed after the government unveiled a plan for large unfunded tax cuts. At one point, the 10-year UK yield spiked over 1 percentage point in a day. 

The Bank of England had to pledge emergency bond buying to stop a bond market meltdown. While the UK faces unique challenges, pundits saw it as a warning for the US and global markets.

Some strategists fear the Fed’s monetary tightening could create similar dysfunction in Treasuries. If there is a wave of forced selling by investors, yields could spike out of control.

In a breakdown scenario, the 10-year Treasury yield could shoot above 4% rapidly. In turn, this could push average 30-year fixed mortgage rates above 6.5%, with jumbo loans even higher.

The last time yields were so high was over 20 years ago. Back in 2000, the 10-year Treasury peaked at 6.9%, driving 30-year mortgage rates to 8%-plus. A return to anything resembling that is a frightening prospect for housing.

Assessing the Impact of Rising Mortgage Rates on the Housing Market

High rates led to tremendous housing pain in the 2000s. From 2005 to 2006, the 30-year average rate jumped from 5.5% to 6.8%. Home prices and sales cratered shortly after. The cycle didn’t bottom until 2011-2012 when rates fell below 4%.

Of course, the most extreme warnings of a complete 2008-style housing and financial market collapse are overblown and unlikely to fully materialize. There are important reasons to take these dramatic predictions with a healthy degree of skepticism. 

Specifically, the conditions that led to the toxic housing bubble and ensuing financial crisis appear far different this time. Regulatory oversight of the banking and mortgage lending industries has increased markedly since 2008, curtailing some of the excessive risk-taking behavior that was rampant during the mid-2000s housing boom.

 Additionally, mortgage underwriting standards today are much tighter than the lax standards during the bubble when loans were freely given even to unqualified buyers. So while higher interest rates will dampen housing affordability and prices, the fundamentals of the housing market still need to be stronger than the precarious stretch leading up to 2008.

Structural factors like demographics should keep interest rates lower than in past decades. An aging population and falling birth rates reduce the demand for capital, leaning against massive rate spikes.

Additionally, most analysts expect inflationary pressures to moderate over time without requiring the Federal Reserve to raise interest rates to excessively high levels. Respected analytical firms like Oxford Economics project that as supply chain issues continue to heal and other inflation drivers stabilize, inflation should steadily fall from current highs. 

They see consumer price inflation dropping to around 3% by 2023. This should eliminate the need for continued aggressive monetary tightening by the Fed. With inflation coming down, the Fed is likely to stop its rate hike campaign, with its policy rate topping out around 4-4.5%. 

This should translate to the 10-year Treasury yield plateauing around 4% as well by 2023 rather than spiking to stratospheric levels. Moderating inflation will alleviate pressure on long-term yields. While the path ahead may still be volatile, current expectations call for inflation to cool without runaway interest rates that could cause severe economic damage.

This should translate to 30-year mortgages peaking around 6%, not 8% or higher. While still elevated, this is unlikely to crash the housing market altogether. Forecasts show home price declines of 5-10% cumulatively, not a catastrophic 25-30% plummet.

Still, even more, moderate rate spikes can have an impact. Many potential homebuyers are already priced out at 5-6% rates, particularly first-timers. Existing homeowners will lose their incentive to tap record-low equity through cash-out refinances. 

The hot pandemic housing market is at risk of stalling out. During past periods of rising rates in 2013-2018, existing home sales fell steeply. Builders may also have to curb new construction if buyer demand falters. 

Predictions of mortgage rates returning to 1990s or 2000s extremes are overblown. But the recent Treasury yield spikes are an important reminder that rates remain vulnerable to Fed actions and bond market volatility. Where exactly the peak will be is uncertain. Homebuyers should brace for further rate pain either way.

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