Hello, 5%

Submitted by Rich Toscano on April 13, 2006 - 8:45pm

The 10-year Treasury yield just busted through 5% for the first time in almost 4 years. Is the global liquidity party finally starting to wind down? Whatever's going on, it bodes poorly for the housing bubble.

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Submitted by powayseller on April 13, 2006 - 10:17pm.

So demand for the 10Yr is down, either because investors expect inflation or foreign central banks are diversifying, as they've told us they would? Could there be other explanations?

(Reduced demand for bonds causes their price to fall, and yields to rise.)

Submitted by LA_Renter on April 13, 2006 - 11:36pm.
Submitted by megaduck on April 14, 2006 - 1:00am.

I've always been a "stocks" guy, mainly because I understand the mechanisms of that market. I only started following the bond market recently, mainly because of housing.

I get the whole "prices fall, yields rise" thing, but I'm still a little fuzzy on the details. How exactly do interest rates get set? My (probably wrong) understanding of bond yields is this:

1. A bond gets offered at a fixed interest rate. Let's assume a hypothetical bond of $100,000 with a duration of 1 year at an interest rate of 10%, just to make the math easy. Total value of the bond at maturity = $110,000.

2. I purchase the bond for $101,000 (a premium of 1%).

3. My yield is 9% once the bond matures. ($110,000 - $101,000 = $9000).

So, who offers the bonds that set mortgage rates? How do they determine the maturity value of that bond? Am I completely bollocksed up, and this isn't how it works at all? These are the parts of the puzzle that I'm missing.

p.s. Rich, if you're reading - awesome site. It's good to hear someone talking sense these days.

Submitted by privatebanker on April 14, 2006 - 7:23am.

This is pretty significant. The 10 yr. was depressed for so long and it has helped fuel the lending frenzy. Many analysts are predicting that once the yield breaks through 5%, it could really take another .20 - .50 basis points run up. Borrowing is getting more and more expensive making it even harder for most to afford a home at these levels. If this trend continues, it's going to really wound the mortgage industry and it's going to throw things in reverse for housing prices. I knew this was going to happen at some point soon. I can now see the Fed feeling comfortable with a few more interest rate hikes.

Submitted by michael on April 14, 2006 - 7:34am.

Stocks:

Your descrition on how bonds work is not quite accurate. It's more along these lines:

You purchase a bond at say $1,000 (called par) and you usually receive a semi-annual payment based on the coupon. We'll use your 10% example also known as the coupon rate. 10% of $1,000 is $100 paid semi-annually or two $50.

As interest rates rise the value of your bond goes down. Let's assume for simplicity that rates jump to 20% from 10%. A new bond investor can now go into the market and purchase a brand new bond yielding 20%. Why would he buy your 10% bond? He wouldn't. Unless you sold your bond at a discount.

So for your 10% bond to yield 20% you would have to sell it at $500. Your coupon payment of $100 paid semi-annualy is now comparable to a 20% yield ($100 / $500). This is known as current yield.

You don't however have to sell your bond and you have the option of holding the bond to maturity. If you bought a new issue bond with a five year maturity, regardless of what happens to interest rates during your holding period, at the end of five years your bond expires at par, or $1000.

Global demand for bonds of maturities ranging from 3 months to 30 years (some parts of the world have 50 year bonds) determines the price and yields of bonds. If investors are afraid inflation will kick in and anticipate central banks having to raise the overnight rate higher, then they start selling their bonds driving rates higher. If investors feel that the economy is slowing, inflation is in check and that the central bank may need to lower rates to stimulate the economy, then they start buying bonds in order to lock in a higher rate before rates go down.

Hope this helps.

Rich - thanks for the blog man, super cool!

Submitted by powayseller on April 14, 2006 - 7:39am.

I have many questions about how the MBS and CMO portions of this, but I'll take a stab at it.

Government bonds are sold at auction to the highest bidder, so the rates are constantly changing based on demand and supply.

The 10yr US government bond is the standard for setting rates for fixed mortgage rates. Since the mortgages are purchased by lenders and GSEs (government sponsored enterprises, such as Fannie Mae, Freddie Mac, Home Loan Association, Ginnie Mae), the mortgage lender will purchase them only at the current rate. You may have heard your broker talk about checking his "rate sheet" for the best loan rate he can get you.

Your lender gets a fee for originating the loan, but wants to free up money to keep originating, since that is his specialty. So he sells the loan to someone else, GSEs or private finance enterprises, whose specialty is the packaging of loans into MBS (mortgage backed securities) and CMOs (collateralized mortgage oblications). These are portions of everyone's mortgages, grouped by risk categories (called tranches), and sold all over the world.

As the yield of bonds change, mortgage rate sheets change too. That's why borrowers refinance their loans. If you held a Fannie Mae bond at 8%, you were really happy, until interest rates came down and your income stream went down, or the borrowers refinanced by the millions, paying back your bond. That's why you read that one of the risks of holding bonds is early payment. You are not guaranteed to keep getting that 8%, because borrowers can refinance and pay you back, and then go on the open market and get a lower rate.

Submitted by LA_Renter on April 14, 2006 - 9:29am.

I agree. IMO the recent rise in bond yields trace their way back to the Bank Of Japan communicating they were taking steps to add cost to their currency a few months ago. That was the shot heard around the world. The easy money from both Japan and Europe was a primary source of demand for US Treasuries. This is known as the Carry Trade. The recent rise in bond yields are the unwinding of that dynamic given that both Europe and Japan are now tightening. This is the first time in over 20 years that all three banks have been tightening at the same time. What I find interesting is that the global glut of liquidity is now finding its way into commodities and precious metals primarily as a hedge against inflation. The rising prices of these assets will find their way into the CPI numbers and cause further tightening by our FED, more than is currently anticipated. Housing is as vulnerable as it can be right now.

Submitted by megaduck on April 14, 2006 - 11:23am.

Thanks, guys. That clears a lot of things up for me.

I could wrap my head around the general concepts, but the specific mechanisms always eluded me. It's hard to find good information out there.

Anyways, much appreciated.

Submitted by megaduck on April 14, 2006 - 11:44am.

If things are like they were over 20 years ago, then housing is truly in trouble.

Looking at historical rates for the past thirty years, it looks like rates for the 30 year fixed mortgage peaked at around 18% in 1981-1982. My understanding is that economic condititions leading to this were similar: Increasing federal deficits, a tightening of foreign monetary policy, and elevated commodities prices. Of course, I was born in the seventies, so I wasn't following international finance at the time. I'd love to get the perspective of someone that "lived through it".

Still, I can barely imagine what interest rates like that would do to the current San Diego housing market.

Submitted by michael on April 14, 2006 - 11:46am.

Check out this link... http://www.federalreserve.gov/releases/h...

It provides data on 10 year treasury yields back to 1953.

Submitted by LookoutBelow on April 15, 2006 - 10:31am.

All of this data evaluation leads to doom. Most people havent got a clue as to the complexity of the situation, but MOST all know the feeling of (meme) "forbodeing" that everyone seems to be feeling presently, These are the actual reasons they feel this way. There is a science dedicated to this phenomenae.

Im convinced I made the right move 2 years ago by selling all the real estate I had (2 houses). Albeit, maybe a tad too early, but as Joe Kennedy used to say, "Only a fool holds out for top dollar"

Submitted by underdose on April 17, 2006 - 2:22pm.

Oddly, I would commend you for getting out a little early. It's a bit of bummer because you missed out on some potential gains, but what it says to me is that you recognized the bubble for what it was years ago, before it was en vougue to admit there was a bubble, and back when almost all PhD's in economics were heralding a "new era" of permanent prosperity through real estate ownership. I'll wager that you, like me, do not have a PhD in economics, or work in any financially related field. I'll bet that you, like me, would be classified by professional investors and setters of economic and fiscal policy as "unsophisticated". So why is it that you and I and Rich and many others on this site saw this coming years ago, yet most of the "experts" didn't have a clue?

More on topic concerning bond yields, I still find it mystifying that the so-called "sophisticated" participants in the bond markets over the past years have done little to punish the deteriorating credit-worthiness of both the American government and the American consumer. I just can't imagine why debt security investors haven't demanded a higher premium for a growing default risk by over-extended home buyers. And I can't fathom why Allen Greenspan, after noting some "froth" in real estate markets, didn't move to tighten monetary supply faster and more aggresively. Why wait until it grows to catastrophic proportions to finally admit, "oh yeah, it's a problem"? Was he hoping to postpone the reckoning until he was safely out of office to try to keep a favorable view of himself in the history books? Was it incompetence? Why didn't any of the "expert" participants move to hinder the bubble's continued development when all of us non-experts saw the problem and would have moved to try to repair it years ago?

Well, you (and I) sold. That was our little contribution to trying to repair it...

Submitted by powayseller on April 17, 2006 - 2:35pm.

Unfortunately, I am excluded from your group of people with foresight. I was amazed that housing kept going up. My brother warned me last spring about a housing bust, and I shrugged it off. After all, I was a homeowner, and I didn't want to consider selling, so I didn't want to believe my house (under construction) could lose value. I told my brother that I could easily absorb any loss, up to 50%, since we'd owned the house so long.

My brother persisted with friendly, casual remarks over dinner, and finally I googled "housing bubble San Diego" last fall, and came across this site. Until then, I didn't understand anything about global liquidity, or that you could get 100% financing, or that Option ARMs even existed.

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