February 13th, 2014 10:29 AM by Narbik Karamian
There is a lot of conversation around mortgage rates lately, especially the 30 year fixed loans.
Below is a graph from FRED (Federal Reserve Economic Data) that gives us a good perspective as to where 30 year mortgage rates have been since the 1970’s along with an article I found very informative from Bill Conerly of Forbes.
As he states, interest rates will remain low, but long-term rates are not quite as low as they have been. That’s the nutshell. Before explaining the numbers and the reasoning, let me explain my view of interest rate determination.
Short-term interest rates are largely determined by the central bank. For those of us in the United States, that’s the Federal Reserve.
Long-term rates are much more market driven. The global average interest rate for long-term debt is the result of global demand for credit compared to global supply of saving. The key item here is the global business cycle, because demand for credit goes up in booms, while the saving rate tends to fall at the same time. I emphasize “global” because capital moves around the world seeking its highest risk-adjusted return.
Long-term interest rates in any particular country result from the interplay of the global average interest rate and some local factors. Expected inflation is the largest factor that shifts one country’s interest rate away from the global average. Expectations of future short-term interest rates also influence the long-term interest rate.
Intermediate interest rates, such as 2-year or 5-year bonds, are a mix of the two sets of factors.
With that framework, here’s what to expect through the remainder of 2014. Short-term interest rates will remain very low, at about the current level.
When the Fed starts to get nervous about inflation, they will first stop buying long-term securities, and then only later they will raise short-term interest rates. That won’t be any time soon, though. The best estimate we have of the economy’s potential shows that actual performance is more than five percentage points short of where we should be, and we are not growing very fast. With large and persistent underperformance of the economy, the Fed won’t tighten any time soon.
Long-term interest rates are a different story. Global demand for credit will expand as the world economy grows. This assumes that Europe does not melt down, a significant risk. It also assumes that China continues to grow, which is quite likely. Global economic expansion will put upward pressure on long-term interest rates worldwide.
Will United States inflation expectations rise? With the large and persistent underperformance of the economy, inflation expectations won’t go too high, though they may edge up from current low levels. Certainly they won’t fall.
Finally, as the economy improves investors will start to wonder if a Fed tightening isn’t around the corner. Right now that corner is very far away, so far away that nobody can see it through the fog of statistics. However, in a year or two, we might reasonably make out the dim outlines of the corner around which the tightening lies.
The result is that I expect gradual increases in long-term interest rates through 2014. I could see that interest rate rising above three percent by the end of 2014, maybe up as high as 3.5 percent. They were as low as 1.72 percent in April, 2013. They are now hovering around 2.75 percent nowadays (For those of us who lived through the era of double-digit rates, roughly from 1979 through 1985, it’s a joke to say “maybe as high as 3.5 percent.”)
This gain in long-term rates will push the 30-year mortgage rate up around 5.5 percent, which is still a low interest rate. However, the move from the threes to the fives will discourage people with cheap mortgages from moving.
Risks to the forecast are fairly simple. I think the chance of short-term rates rising over the forecast time horizon is very, very low. Long-term rates could remain at today’s low levels if the economy re-slumps. However, a surprise rebound in economic growth worldwide could add another percentage point to my forecast. But the high interest rates of 20-30 years ago will remain but a distant memory no matter how surprising next year’s economy turns out to be.