Mortgage Rates in 2010 – Up, Down, or Sideways?

Forbes Magazine recently published a commentary piece on the direction of interest rates (”The Top 10 Items Shaping Interest Rates in 2010“), which I want to adapt to mortgage rates. Here goes:

1. The Economy: According to Forbes, mediocre economic growth and low inflation will allow the Fed to hold short-term rates at 0% for most of 2010. Personally, I think these predictions (both that GDP growth will remain lackluster and that the Fed will hold rates) are accurate. The variable, as I see it, is inflation, which is due to rise in line with the explosion in the money supply (70% in 2009). If inflation takes off before the economy, the Fed will face a very serious dilemma, and could be forced to hike rates prematurely.

2. Fed Portfolio – At the moment, this is probably the single most important factor underlying mortgage rates. The Fed spent $1+ Trillion in 2009 buying mortgage-backed securities, sending rates down below 5%. Not only is the Fed no longer adding to its portfolio, but it could soon even begin unwinding some of these securities, in order to guard against inflation. This, alone, would place enormous upward pressure on mortgage rates. While doves think the Fed may resume its purchases, this seems unlikely.

3. The Banks – Forbes predict that banks will “forsake credit risk and become big takers of interest-rate risk instead.” The implication is that if/when the Fed begins to offload its portfolio of mortgage securities, banks will step in to buy them. What this means for mortgage borrowers is that on the one hand, it will remain difficult to obtain mortgages, but that on the other hand, those that are lucky enough to get approved could be offered very attractive rates.

4. Foreign Investors – A recovery in the economic fortunes of foreign governments could lead to a proportional rise in the size of their investment portfolios and foreign exchange reserves. If a significant amount of such capital finds its way into the US, it will likely be invested in US Treasury Securities. That would send Treasury yields downward, and exert strong downward pressure on mortgage rates, which usually trade at a consistent premium to Treasury rates.

5. Budget Deficits – The US government is expected to run record deficits for as long as the eye can see. While demand for new Treasury issuance will likely remain strong, the fact that supply will be just as strong could tax (no pun intended) the capacity of investors to continue funding them. If the US doesn’t get its fiscal house in order, it could face increased borrowing costs, in the form of higher rates.

6. New Regulation – Forbes argues that an imminent enhancement of financial sector regulation will result in “wider interest-rate differences between liquid markets and everything else.” Fortunately, the market for mortgage-backed securities remains among the most liquid, although less so for subprime issues. In other words, while rates for AAA borrowers could remain low, subprime borrowers will likely see higher rates.

7. Fannie Mae, Freddie Mac – The government recently pledged its undying support for these two mortgage behemoths. While this is bad news for taxpayers (they have already absorbed more than $100 Billion in government funding, together), it is good news for borrowers, especially because the overwhelming majority of new mortgages these days ultimately find their way to Fannie or Freddie.

8. U.S politics – The legislative branch is currently mooting a curtailing of the Fed’s powers and subjecting it to greater scrutiny. Some experts have speculated that this would make the Fed more dovish in conducting monetary policy, since it would have to answer to Congress if the economy suffered. Thus, if the “Audit-the-Fed” bill is passed, don’t expect short-term rates to rise anytime soon.

9. International politics – Forbes writes that a steady stream of international “conflict” will ensure that risk aversion remains at the fore of investors’ minds. As a result, they expect demand for US Treasury securities to remain high. Given the iron-clad guarantee that the government has extended to Fannie and Freddie, demand for mortgage backed-securities should also remain strong among the risk-averse set.

10. Everything Else – There are a handful of minor factors that Forbes list, but I won’t bother repeating because they pale in comparison to what’s listed above.

So, how can we make sense of all of this? In short, the economy is growing, and so may inflation. The Fed will start to sell some of its mortgage debt, but banks and foreign investors will step in to buy it. My prediction is that all mortgage rates will creep up, but long-term (fixed) rates will rise faster than short-term (variable) rates, and sub-prime rates will rise faster than rates for prime borrowers.\