Lawler: Update on Mortgage/Treasury Spreads

Today, in the Calculated Risk Real Estate Newsletter: Lawler: Update on Mortgage/Treasury Spreads

A brief excerpt:

From housing economist Tom Lawler:

Last May I wrote a two-part piece on why the spread between the 30-year fixed-rate mortgage rate and the 10-year Treasury rate had widened significantly from the end of 2021 to early May of last year, and explained why changes in the yield curve, changes in market-implied interest rate volatility, and the end of the Federal Reserve’s misplaced MBS purchase program all logically and rationally resulted in a widening of the mortgage/10-year Treasury spread.  I also said that it was unlikely that mortgage/10-year Treasury spreads were unlikely to revert to what some argue is the “normal” level (there is no such thing) any time soon.  Since then, mortgage/10-year Treasury spreads have on average been wider than there were last May, for the most part for logical and rational reasons based on what has happened to the yield curve and implied interest rate volatility. ...

Since mortgage cash flows are very much interest-rate path dependent, the “expected” value of mortgage cash flows across all possible interest-rate paths is heavily dependent on the probability distribution of future interest rates.  If market expectations of future interest rate volatility were low, one would expect relatively low mortgage/Treasury spreads, while if market expectation of future interest rate volatility were high, one would expect relatively wide mortgage/Treasury spreads.

The shape of the yield curve also impacts that probability distribution of future interest rates.  A very steep yield curve implies a market expectation of increasing future interest rates, and future rate simulations are typically “centered” around this rising “base case” scenario (with possible adjustments for estimated term premia).  An inverted yield curve, in contrast, implies a market expectation of declining future interest rates, with future rate simulations centered around this falling “base case” rate scenario.  As such, a simulation of future rates with an inverted curve “produces” more rate scenarios where borrowers exercise their prepayment option, implying that mortgage/10-year spreads will be narrower with a steep curve and wider with an inverted curve.

To sum up, one would expect mortgage/10-year spreads to be (1) wider when interest rate volatility is high; and (2) wider when the Treasury yield curve is inverted.  And when interest rate volatility is high AND the yield curve is very inverted, one would expect the mortgage/10-year spread to be VERY wide.

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