The Power of Expectation

Mortgage rates continue to be the lead story in the financial press, and for good reason – rates are up a full-percentage point over the past month and are now at July 2011 levels.

It's understandable that the spike in mortgage rates would slow refinance activity. Indeed ,that's been the case: Refinances have dropped considerably over the past month, and the latest weekly data show yet another drop, with activity falling 5%. Refinances are now at a two-year low, and their percentage of overall lending has dropped to 67%.

Purchase activity is a different story: Purchases were up, rising 2% from the previous week. Total purchase applications are actually up 16% year over year, indicating homebuyers have yet to be put off by rising mortgage rates.

We've written frequently about expectations. If buyers expect lower prices, they'll frequently (but not always) wait for lower prices. We saw a lot of that behavior when mortgage rates were trending lower. Many borrowers, especially on the purchase end, would wait and wait and wait. (Refinancers were more willing to act, knowing if rates continued to drop they could refinance again.)

On the other side of the coin, people tend to be spurred into action by rising prices. They don't want to pay more tomorrow for what they can get cheaper today. We've seen that in the purchase market over the past month. Home prices have been rising steadily over the past 18 months, but now mortgage rates are rising too. More borrowers (and most lenders, for that matter) don't expect to see a return to the ultra-low rates of a couple months ago. Many believe the trend has shifted and rising rates are the new norm.

We think rising rates are the new norm too. We say that because credit markets are much more sensitive to the Federal Reserve and the prospect of it curtailing its mortgage-backed securities (MBS) purchases.

When the Fed curtails (or even hints at curtailing) its purchases, interest rates will rise, which means today's bond investors will suffer losses. (When interest rates rise, the price of fixed-income investments like bonds fall.) Obviously, these investors don't want to suffer losses, so they'll sell if they think demand for bonds and fixed-income securities will fall.

Of course, we can't predict with certainty whether mortgage rates will move higher in the near future. After all, a significant macro event – a major terrorist attack, a large bankruptcy, a European bank run – could spur money to flow back into haven investments, like U.S. Treasuries and MBS.

That said, we see higher rates and more volatile rates as the likely scenario. For this reason, we continue to say that waiting is the real risk in this market.

 Courtesy of Jessica Regan.

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