Why rates are doing what they are doing: Reality check for U.S. bond binge

Tom Petruno, Market Beat
June 6, 2009

Here is the way it was supposed to work: Uncle Sam would borrow and spend trillions of dollars to save the economy and the financial system, but interest rates would stay near rock-bottom and nobody would worry about the potential side effects of all that spending — like, say, inflation or a devalued dollar.

Things aren’t proceeding quite according to plan. The investors who are supposed to buy all of that new Treasury debt are rebelling, driving interest rates up.

U.S. unemployment rate hits 9.4% in May…
That’s exactly what the housing market doesn’t need. The average 30-year mortgage rate rose to a six-month high of 5.29% this week from 4.91% the previous week, according to Freddie Mac.

And that was before Friday’s big jump in Treasury bond yields, which are the benchmarks for many other interest rates, including home loan rates and municipal bond yields.

The 10-year Treasury note yield rocketed to 3.86%, up from 3.71% on Thursday and the highest since November.

Compared with the many financial catastrophes of the last nine months — the failure of Lehman Bros., the partial nationalization of Citigroup Inc., the bankruptcy of General Motors Corp., etc. — a 3.86% yield on a Treasury bond would hardly seem to rank as a national tragedy.

But it’s the trend that’s important here, and the broader implications. Even as Federal Reserve Chairman Ben S. Bernanke was on Capitol Hill this week warning that the U.S. risks borrowing its way into yet another crisis, Treasury Secretary Timothy F. Geithner was in China trying to assure the largest foreign owner of Treasury bonds that its investment was safe.

Rate Watch

After an unprecedented 5 month period of relative stability, rates shot up yesterday to levels not seen since November 2008.

Conforming 30 year fixed rates, for example, opened the day at 5.25% at 1 point on a 60 day refinance transaction and at last look are now at 5.75% at 1 point. That’s an increase of 1/2% in rate.

Why is this happening?

• Increased volatility associated with massive selling of Treasury and mortgage backed securities as well as a lack of buy side positioning to offset the declines.
• While the capital markets are extremely liquid for agency issued (Fannie Mae and Freddie Mac) mortgage securities there has been a tremendous participation by the Federal Government to step in and absorb any excess supply as it enters the system. Today this has not yet happened.

Please remember that we have had a tremendous run and by some accounts the levels that we have seen in terms of the dollar price of some of these discounted mortgage backed securities may not be seen again for years to come. Regardless, this type of pullback is to be expected. Historically rates are still low and the next several days will prove to be very interesting to see if the Fed once again steps in to support the excess supply that has hit the street.