How Will Mortgage Rates Fare Under Fed Tightening?

Written by Les Parker
on December 19, 2016 No Comments
Categories : Blog View

BLOG VIEW: The Fed, after over 18 months of dithering, is finally embarking on a strong dollar policy. That is what I see as the ultimate consequence of the Dec. 14 announcement by the Federal Open Market Committee to hike interest rates by 0.25%.

Why does this matter to mortgage originators? There are several reasons. First, a strong dollar policy favors a strong foreign exchange rate for the U.S. dollar. That will force debt-ridden economies to deal with the leverage because their assets will be less valuable in U.S. dollar terms. Weak collateral leads to delinquency and write-downs and various forms of debt forgiveness.

Think about U.S. residential real estate from 2007 to 2015. The same thing has been happening in emerging markets. Brazil in 2014 is a great example. Brazil went on sale via significant devaluation because of the U.S. Fed “taper tantum,” a.k.a., quantitative easing long exit. U.S. 10-year yields fell to 1.87% (our forecast was 1.9% in 2014), and mortgage rates dropped to near 3.9%, according to Freddie Mac’s Primary Mortgage Market Survey.

The chart below shows that under quantitative easing, the 10-year rose, but with declining or no quantitative easing, 10-year yields fell.

 

Second, falling asset prices in some countries outside the U.S. tend to get messy, so international investors will cling to safe investments – namely, U.S. Treasuries of all maturities, but particularly the U.S. 10-year. So, some countries will go on sale, such as the U.K. after BREXIT on June 23, which saw a 15% devaluation in 24 hours.

Fed policy anticipation by the fixed-income market tends to go in the direction of the Fed signal but then goes opposite when the policy is actually announced. Since BREXIT, the Fed has tried to talk tightening and the 10-year yield rose somewhat. Then came the Trump bump. It changed the game, adding positive anticipation of more growth, higher wages and inflation. Mortgage rates bottomed in July and have risen to 4.16% in Freddie Mac’s survey as of Dec. 15.

So, where will mortgage rates go during 2017? The short answer is this: Rates will go down, and then they will increase, with high volatility.

In the first quarter of 2017, I see emerging market stress from the stronger dollar as supported by a tightening Fed. Emerging countries and businesses that have debt denominated in U.S. dollars will find that paying off the dollar debt becomes more expensive as they pay with their local currency that’s losing value against the dollar. Along with that I see the 10-year Treasury Note yields will drop significantly. Revisiting the late September 2016 or early July 2016 lows can reasonably be expected. Of course, that should spark a sharp increase in refinances because consumers will see this for what it is – a last shot to lock in generational low yields. It will modestly support the purchase money market because low inventories are the major constraint.

But here is the rest of the story for 2017: After markets deal with the emerging markets issues, with the strong dollar; protectionist trade rhetoric out of U.S.; and banks that have the bad debt exposure, I see a liquidity crisis as investors exit Treasuries to get into riskier investment. The great reallocation will lead to some spectacular mortgage banking failures. They will not be able to handle the margin calls. Others will fail to manage the pipeline risk with the industry-pervasive reactive risk management models.

The flood of servicing portfolios will also hurt the financial performance mortgage bankers. Increased volatility is always the enemy of financial institutions, and 2017 will be no different.

The winners in 2017? Mortgage bankers that have quality underwriting and manufacturing and strong purchase money strategies, as well as a nimble refinance model.

Les Parker is senior vice president of strategic business development for LoanLogics, a provider of mortgage origination software.

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