Fixed mortgage rates dropped to historic lows in 2020 as a result of the Federal Reserve lowering the target for the fed funds rateto virtually zero on March 15, 2020. The Fed's interest rate cuts were in response to the COVID-19 pandemic and the resulting recession.
Investors fled to the safety of government securities pushing yields on the10-year Treasury note to an all-time low of 0.52% on Aug. 4, 2020.As a result, mortgage rates fell since they tend to follow the yields on U.S. Treasury notes.
However, by 2022, the Fed was hiking rates to combat inflation, and by May of 2022, the 10-year Treasury yield had risen to nearly 3.5%, pushing mortgage rates to over 5%.
Key Takeaways
- Treasury bonds are one of the world's safest investments.
- As with any bonds, when Treasury prices go up, there is a corresponding drop in yields.
- Fixed mortgage rates follow Treasury yields.
- The best time to get a fixed-rate home loan is when Treasury yields are low.
How Mortgage Rates Follow Treasury Yields
U.S.Treasury bills, bonds, and notesare a bellwether for fixed mortgage rates, as shown by the chart below.
So how exactly do Treasury yields affect interest rates? Investors who want a steady and safe return compare the interest rates of allfixed-incomeproducts.They compare yields onshort-termTreasurys tocertificates of deposit (CDs)andmoney market funds. They compare yields on long-term Treasurys tomortgage-backed securities andcorporate bonds. All bond yields are affected by Treasuryyieldsbecause they compete for the same type of investor.
Note
Treasury notes are safer than any other bond because the U.S. government guarantees them.
CDs and money market funds are slightly riskierfor investors since they aren't guaranteed.To compensate for the higher risk, they offer a slightly higher interest rate. But they arestill safer than any non-government bond because they are short-term.
Mortgages, in turn, offer a higher return for more risk. Investors purchase securitiesbacked by the value of the home loans—so-calledmortgage-backed securities. When Treasury yields rise, investors in mortgage-backed securities demand higher rates. They want compensation for the greater risk.
Those who want even higher returns may purchasecorporate bonds. Ratingagencies likeStandard and Poor'sgrade companies and their bonds on the level of risk. These bond prices affect mortgage rates because bonds and mortgages compete for the same low-risk investors who want a fixed return.
Fed Funds Rate and Adjustable-Rate Mortgages
Treasury yields only affect fixed-rate mortgages. The 10-year note affects 15-year and 30-yearconventional loans.
For adjustable-rate mortgages (ARMs), it's the fed funds ratethat has the most impact. The fed funds rate is the ratebankscharge each other for overnight loans needed to maintain theirreserve requirement. It influences the prime rate, which is a benchmark used in pricing loans. The Fed has lowered the target for the fed funds rate to a range of 0% to 0.25% just two times in history, once amid the 2008 financial crisis and once in March 2020.
How Treasury Notes Work
The U.S.Treasury Departmentsellsbills, notes, and bondsto pay for theU.S. debt. It issues notes in terms of two, three, five, seven, and 10 years. Bonds are issued in terms of 20 and 30 years. Bills are issued in terms of one year or less. People also refer to any Treasury security as a bond, Treasury product, or Treasury. The 10-year note is the most popular product.
Treasury Auctions
The Treasury sells bonds at an auction. It sets a fixed face value and interest rate for each bond. If there is a lot ofdemandfor Treasurys, they will goto the highest bidder at a priceabovethe face value. That decreases the yieldor the total return on investment. That's because the bidder has to pay more to receivethe stated interest rates.
If there is not a lot of demand, the bidders will pay less than the face value. That increases the yield. The bidder pays less to receive the stated interest rate. That is why yields always move in the opposite direction of Treasury prices; to keep up with current interest rates, the prices and yields on bonds that trade in the open market are continually readjusting.
Note
Treasury note yields change every day. That's because investors resell them on thesecondary market.
Treasury Demand and Mortgage Rates
When there's not much demand, bond prices drop, and yields increase to compensate. That makes it more expensive to buy a home. And when buyers have to pay more for their mortgage, they are forced to buy less expensive homes, which encourages builders to lower home prices.
Low yields on Treasurys mean lower rates on mortgages. Homebuyers might then afford larger homes. The increased demand stimulates thereal estate market, which boosts the economy. Lower rates also allow homeowners to afford asecond mortgage. They'll use that money for home improvements or purchasing more consumer products. Both stimulate the economy.
Frequently Asked Questions (FAQs)
How do you buy 10-year Treasury bonds?
TreasuryDirect is a government website that allows you to buy Treasury bills, notes, and bonds directly at auction. If you have a brokerage account, you can trade bonds on the secondary market. There are also bond ETFs that allow investors to target various parts of the bond market.
How do you short the 10-year Treasury?
You can short 10-year Treasury notes by asking your brokerage for permission to open short positions. Shorting is as easy as selling Treasuries on the secondary market before you own them. There is also a futures contract (ZNH2) that tracks the 10-year Treasury rate, and traders can use that as a tool for hedging or shorting.
