Treasuries To Contribute To The Surge In Mortgage Rates

Earlier, I noted that the Federal Reserve's decision to stop purchasing mortgage-backed securities (MBS) should cause an increase in mortgage rates. But that won't be the only thing driving up long-term rates: the Treasury's trouble going forward in selling debt will also contribute to higher mortgage rates, according to a Morgan Stanley economist. Here's what he says, via Bloomberg:

Yields on benchmark 10-year notes will climb about 40 percent to 5.5 percent, the biggest annual increase since 1999, according to David Greenlaw, chief fixed-income economist at Morgan Stanley in New York. The surge will push interest rates on 30-year fixed mortgages to 7.5 percent to 8 percent, almost the highest in a decade, Greenlaw said.

Yikes! Those are some pretty high mortgage rates -- and much higher than we're used to seeing over the past several years. They should cut significantly into the demand for refinancing and even new home purchases. Rates like that could also worsen the foreclosures crisis, as many adjustable rate mortgages (ARMs) have benefited from historically low interest rates. Once they adjust to near, or over, double-digits, many more homeowners with ARMs will be force to fold.

The cause of this increase in mortgage rates comes from what this economist believes will be a higher yield demanded for government Treasury securities. Those are generally considered risk-free rates, so any mortgage bearing a similar long-term coupon will consist of its default risk premium added to that risk-free rate.

Bloomberg explains that the government debt will become more expensive because of both supply and demand:

The U.S. will face increased competition from other debt issuers, spurring investors to demand higher yields as the Federal Reserve ends a $1.6 trillion asset-purchase program, according to James Caron, head of U.S. interest-rate strategy in New York at Morgan Stanley. The central bank was the largest purchaser of Treasuries in 2009 through a $300 billion buyback of the securities completed in October.

The Treasury will sell a record $2.55 trillion of notes and bonds in 2010, an increase of about $700 billion, or 38 percent, from this year, Morgan Stanley estimates. Caron says total dollar-denominated debt issuance will rise by $2.2 trillion in the next 12 months as corporate and municipal debt sales climb.

So in addition to the pressure that I mentioned earlier stemming from the Fed's departure from the MBS market, the broader investment community will likely drive rates higher on long-term debt as well. While bad news for the housing market, this is probably good news for sensible investing.