The Bond Market May Be a Red Flag for Mortgage Rates

Mortgage rates have been so low for so long that borrowers have come to look at 30-year rates below 4 percent as being normal. The truth is, that is far below normal, and recently the bond market has waved a bright red flag signaling that the end of super-low rates may be near.

In just over a week at the beginning of May, yields on 30-year Treasury bonds jumped by 32 basis points. If 30-year mortgage rates follow suit, they will be back around the 4 percent mark, after having spent most of the year so far below 3.70 percent. Two key questions, then, are whether mortgages will follow the lead of bond yields, and whether the rising trend will continue.

Bonds and borrowing

Why are bonds a good indicator of where mortgage rates may be heading? To a large extent, a bond and a loan represent the same thing. Organizations, such as corporations, municipalities, and the US government issue bonds as a way of borrowing money. They pay periodic interest as a result, and pay the principal back on a specified date. A loan is very similar, except that the principal is usually paid back gradually over time rather than all at once at the end.

The similarity between bonds and borrowing makes them sensitive to some of the same things - most notably, inflation. Bond buyers and lenders want to make sure they earn enough interest to cover rising prices. If they sense inflation is rising, they will demand higher interest rates. This seems to be a major factor in what has driven bond yields higher recently.

Gas and labor pains

According to the Bureau of Labor Statisics (BLS), the inflation rate was negative for three straight months around the turn of the year before moving back into positive territory more recently. That period of deflation was instrumental in encouraging mortgage rates to move lower. However, the picture is changing. Not only has inflation risen in recent months, but there are two key reasons to believe that it will continue to do so: gas prices and labor costs.

After falling spectacularly last year, gasoline prices have been on the rise since the end of January. The US Energy Information Administration reports that after bottoming out at $2.13 a gallon in late January, gas prices had risen 30 percent by mid-May. This is bound to put some upward pressure on inflation.

Labor costs might also be a factor. The BLS reported that employment growth topped 200,000 in April, and has been generally strong over the past year. As a result, through the end of the first quarter average employee compensation had risen by 2.6 percent over the prior 12 months. That might not sound like an awful lot, but it is the highest year-over-year compensation growth in more than six years. Like gas prices, labor costs are also an important influence on inflation.

As noted above, both bonds and mortgages have reason to be sensitive to rising inflation. Bond yields give a more immediate reading of the reaction, since they are traded constantly in global financial markets. If those bond yields are any indication, home loan rates could be headed higher.

Buyers and sellers have a common enemy

So what should consumers make of the prospect of rising mortgage rates? Normally, one thinks of buyers and sellers as being on the opposite side of a transaction, but in the case of rising interest rates, they should actually view them as a common enemy.

For buyers, of course, higher rates mean borrowing would be more expensive. This might impact how much house they can afford, or possibly even whether or not they can afford to buy. Therefore, people who have been considering buying a home should get into the market decisively now, to get in ahead of the possibility of rising rates.

As for sellers, their concern about rising rates is that it could slow down demand for housing. So, people looking to sell should start actively marketing their properties, and make sure they are competitively priced.

In the middle, between buying and selling, are long-term owners planning on staying in their homes. They too can be impacted by rising rates. Homeowners in that position should consider any refinancing or home equity borrowing now, before it gets more expensive.

Viewed historically, there is an inevitability to higher mortgage rates, simply because rates over the past few years have been so extraordinarily low. Economically, the inflation factors may be coming into place that will push rates more back towards normal.

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