The first place to start when trying to understand how mortgage rates rise and fall is where the money to fund mortgages comes from. Mortgage money comes from a variety of sources, including deposits at banks, but most of the funds come from investors through what is collectively known as "capital markets." Capital markets are where investors go to purchase securities like Treasury notes, corporate bonds, or Mortgage Backed Securities (a package of home loans bundled together into one asset).
Mortgage Backed Securities, the main funding source for home loans, compete against other long-term securities like bonds and treasury notes for the same investment dollars. Since Mortgage Backed Securities compete against these other securities, lenders will adjust homes loan rates to make the return on Mortgage Back Securities competitive relative to other securities. The gold standard of long-term investment securities is the US Treasury Note.
30 year mortgages are traditionally priced using the yield on 10 Treasury notes. The reason for this is simple. US Treasury notes are backed by the "full faith and credit" of the United States, so they are the benchmark for many securities, including Mortgage Backed Securities.
Since home loans are competing for investment dollars with Treasury notes, in most cases when the yield on Treasury notes increases, lenders must raise mortgage rates in order to keep Mortgage Backed Securities competitive with Treasury notes. The opposite happens when Treasury note yields fall; lenders lower mortgage rates.
So if mortgage rates typically go up when Treasury yields rise, and down when yields fall, what makes Treasury yields go up or down? This is where things get extremely complicated, and the easy answer is that there are a multitude of market factors that determine the movement of Treasury yields. But for the sake of this discussion, let's boil down those market factors and try to make sense of when and why mortgage rates move.
Because most investors don't hold bonds until they mature, the current market value of bonds affects the bond yield. As bond prices increase, the yield decreases. So as the bond market improves, and bond prices increase, the Treasury note yield goes down. Since 30 year loan rates are pegged to 10 year Treasury notes, when bond and Treasury yields go down, mortgage rates go down.
So what makes bond prices go up or down? One major factor affecting bond prices is inflation. As a general rule, when economic times are good and employment is high, inflation tends to rise. Inflation is the enemy of long-term bond holders. The reason for this is simple. Bond holders are paid yearly interest, but the true value of these interest payments is reduced by inflation.
Typically, as the economy improves bond prices goes down as investors begin pricing inflation into the value of bonds and treasuries. Remember that we learned earlier that bond prices and bond yields moves opposite of each other. When bond prices go down, yield prices go up. So if mortgage rates track the yield on US Treasuries, when bond prices go down, mortgage rates go up.
Other factors that affect mortgage rates are employment, homes sales, and consumer confidence. Mortgage rates are more susceptible to economic activity than treasuries, mainly because the average home buyer may lose their job or be unable to make their mortgage payment, while the US Treasuries are considered the safest investment in the market. For this reason, jobs reports, Consumer Price Index, Gross Domestic Product, Home Sales, Consumer Confidence, and other data on the economic calendar can move mortgage rates significantly.
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