What Does a Bond Market Collapse Mean for Mortgage Rates?

  • The U.S. bond markets have been vitriolic all year, with some long-duration Treasuries falling even more than stocks.
  • It’s rare to see stocks and bonds fall at the same pace, and this may prove an indicator of further economic deterioration.
  • Ahead of the Federal Reserve’s anticipated rate hike next week, many economists fear further pressure on Treasuries will spill over to mortgages, which closely track 10-year bonds.
mortgage rates - What Does a Bond Market Collapse Mean for Mortgage Rates?

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With bonds seemingly decoupling from stocks lately, Treasuries have become a point of concern in the financial world. Many long-duration Treasury bonds, considered a premier low-risk investment option, are down substantially this year. In some cases, they are even out-bearing stocks.

Mortgage rates have long tracked the 10-year Treasury bond. Should interest rates keep going up, pushing up bond yields in the process, the effect on home affordability could prove devastating.

It’s important to establish what defines a “bond market collapse.” The U.S. isn’t at a point where the threat of illiquidity could push bonds into default. Rather, bonds are currently undergoing a massive selloff that may well worsen in the months to come.

Bonds are, in many ways, a reflection of our greater financial systems. A proxy for borrowing costs, the 10-year Treasury is considered a gauge of the health of both equity markets and the global economy. A collapsing treasury market could set the stage for more economic deterioration than many appreciate, especially as it pertains to major lending rates.

So, what’s going on with the bond market lately?

Bond Prices Are Sinking, Yields Are Skyrocketing

The 10-year is perhaps the single most sensitive barometer of changes in the U.S. lending environment. When the Federal Reserve dropped lending rates to nigh zero at the outset of the pandemic, the 10-year’s yield hovered around 0.5%. Reasonably so, as with such a small yield, investors were incentivized to pursue higher risk/return stocks. Nowadays, however, things are a bit different.

Since the Fed started reversing course, repeatedly raising interest rates throughout the year, the 10-year’s yield has skyrocketed. Currently, the bond is trending at 4.1%, up from 1.5% a year ago and at the highest level since 2007.

Bond prices and yields move in opposite directions. When bond yields rise — or, in other words, when bond prices fall — it’s typically a reflection of weakening demand for fixed-income investing options. When investors sell off their bonds in favor of higher-return stocks, this pushes bond yields up and bond prices down in the process. And the stock market should theoretically benefit. Currently, however, it seems investors are abandoning both long-term treasuries and stocks. And fast.

Bond Losses Are Outpacing Stocks

Vanguard’s Long-Term Treasury Fund (NASDAQ:VUSTX) and iShares 20+ Year Treasury Bond (NASDAQ:TLT), both measures of long-duration Treasuries, are each down more than 30% this year. Meanwhile, the S&P 500 has fallen about 20%. This is unusual. Bonds are considered a safer bet than stocks, and they almost always move in opposite directions.

Bonds are the fixed-income safety net of the investment world. When stocks are down, bonds tend to gain in value, and vice versa. In fact, the last time bonds didn’t go up when stocks fell was in 1969. It’s troubling that investors are selling their positions in long-duration Treasuries, functionally just government debt obligations, faster than stocks this year.

Looking at the Bloomberg US Aggregate Index, which measures bonds of all durations, 2022 is on track to be the worst year ever for bonds. If the year came to a close today, it would mark the worst annual bond return in the past century.

As 10-year Treasury returns rise, the cost of debt typically comes along for the ride. This means more expensive student, credit card, car and home loans. In fact, perhaps unsurprisingly, 30-year fixed mortgages, which closely track the 10-year, have trended over 6% for most of the year, for the first time since the Great Recession.

Bonds, Mortgage Rates and Home Affordability

Mortgage rates have tracked roughly 300 basis points above 10-year treasury yields for practically forever. This explains why even the idea of rising interest rates can scare investors out of the bond market, forcing mortgage rates and bond yields up in the process.

What’s most alarming given this relationship is that the Fed is likely to continue raising interest rates for the foreseeable future. The central bank is expected to hike rates an additional 75 basis points at its November meeting. This would push the Federal Funds rate, the basis for treasury and mortgage rates, to roughly 4%. That’s the highest level since 2007.

Higher interest rates mean higher bond yields, which mean higher mortgage rates. With mortgage rates already at record levels, further tightening could push home affability into uncharted territory. Should 10-year yields climb to 5%, or even 6%, which isn’t a major leap above their current levels, the 30-year fixed rate mortgage could easily approach 10%.

While some history buffs may argue that this is still well below the peak 18% lending rates felt in 1981, this is a false narrative. Back then, homes didn’t cost seven times the median income level. Real estate prices have run well ahead of wage growth over the past decade. Should mortgage rates continue on the path Treasuries are carving out, home affordability may reach its worst point in modern U.S. history.

Going forward, many economists have their eyes fixated on the bond market. Whether it corrects itself naturally over time or stumbles further into the red, taking mortgage rates to new highs in the process, remains to be seen.

On the date of publication, Shrey Dua did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

With degrees in economics and journalism, Shrey Dua leverages his ample experience in media and reporting to contribute well-informed articles covering everything from financial regulation and the electric vehicle industry to the housing market and monetary policy. Shrey’s articles have featured in the likes of Morning Brew, Real Clear Markets, the Downline Podcast, and more.

Article printed from InvestorPlace Media, https://investorplace.com/2022/10/what-does-a-bond-market-collapse-mean-for-mortgage-rates/.

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