Bond Market Chokes on US Debt, Mortgage Rates Soar
The recent rise in mortgage rates is largely due to the bond market's response to global economic and geopolitical factors. Before the Iran war began, 30-year fixed mortgage rates were dipping below 6%, but have since risen to nearly 7%. This increase translates to an additional $210 per month on a $320,000 mortgage, which is roughly what it takes to buy the typical home in the Philadelphia region.
The bond market's turmoil can be attributed to several factors, including the massive amount of new government debt being issued, the Federal Reserve's silence on interest rate policy, and the ongoing war in Iran. The 10-year Treasury yield, which sets the tone for mortgage rates, has risen by more than three-quarters of a percentage point since before the war.
The Iran conflict has pushed inflation to near 4%, double the Federal Reserve's target, and flipped expectations from cutting interest rates to raising them. This accounts for roughly half the increase in mortgage rates. However, investors still believe the Fed will manage inflation, but their uncertainty is reflected in the term premium, a 'nervousness fee' for lending over long periods.
The bond market's primary concern is the nation's runaway debt, which this year will exceed $2 trillion and equate to more than 6% of GDP. The government has been posting large budget deficits since the pandemic hit in 2020. Foreign investors, who held about half of US debt a decade ago, now hold closer to a third.
The Treasury is attempting to mitigate the impact by doubling its bond buybacks and requiring Fannie Mae and Freddie Mac to purchase mortgage-backed securities. However, these measures have had limited success and may even exacerbate the problem of fiscal dominance, where government borrowing needs pressure the central bank to keep interest rates artificially low.
While there is a possibility that the 10-year yield will fall back this fall, easing mortgage rates toward 6%, several factors need to align. The risk of a serious sell-off in the bond market pushing the 10-year yield towards 6% and mortgage rates towards 8% is considered significant, with odds at around 1-in-5 over the next year.