Why are Interest Rates Rising?

In November 2021, the Federal Reserve began its tapering process, a reduction of its mortgage and U.S. agency securities purchases. Then, in December 2021, in response to tremendous political pressure and in efforts to combat the rapid rise of inflation, it announced an escalation of its tapering schedule.

The Fed is now buying less than the market initially priced in and, assuming there is no change in this new schedule, it will cease its purchases faster than was initially planned. The market is now responding, and interest rates are rising. In just the past two weeks, 30 year fixed rate mortgages have moved upwards almost 13% from +/-3.2% to 3.6%. 

Basic Pricing Principals

First, we must understand how mortgage rates are priced. The easiest way to think about mortgage-backed securities is to understand bond pricing fundamentals. All other things being equal, pricing is a response mechanism to supply and demand with the interest rate representing a measure of competition. As the Fed winds down its purchases, excess mortgage securities are available each month within the market and, presumably, demand will not have changed. The market’s reaction to this change is to move rates upwards. This is due to an increased supply relative to existing demand. There is now less competition in quantity of product and to attract the same interest in quantity of demand, the rate, also the return on the asset, must increase.

A slightly more technical answer is that rate and price (value) are inversely related. As rate goes up, price (value) goes down, and vice versa. Rate is a representation of competition and, by extension, demand. We can prove this with the final product, retail mortgage interest rates, and see that as interest rates have been driven downwards over the past several decades, price (value) has been driven upwards. This represents a measure of relative affordability but is evidence of the inverse relationship just the same. With bond pricing and mortgage security pricing, the supply dictates the price which dictates the rate, all other things being equal.

In a more broad and active investment market context, a mortgage security represents an instance of fixed rate debt in the same way as any other type of bond. You invest “X” dollars, you will be paid a coupon (rate of return), and you will invest over a pre-determined period. This could be in the form of a corporate bond, municipal bond, treasury bond, etc. Excess product, regardless of market, must react and adjust to maintain demand. Otherwise, the individual product or asset class altogether will disappear.

Understanding the Market

At the highest level, mortgage interest rates are influenced by the push and pull effects of the market and broader economy. Many believe that mortgage interest rates are priced based on specific treasury yields. While treasury yields do influence various interest rates within markets, they are not the direct pricing vehicle for mortgage interest rates. Supply, demand, competition, and expectation forces are the principal drivers. Because mortgages are priced over the long-term, their pricing is relative to alternatives and the quality and safety of those alternatives. They are measured by how much demand exists on the market at any given time when considering the options of the investor and what they may or may not achieve within alternate vehicles.

What we Should Make of Rate Increases

Today, we are seeing both Fed drawbacks on mortgage purchases, thus increasing market supply, and market concerns over inflation, which affects future pricing, ultimately leading to the net upward push of interest rates. The question that is then posed is almost always, should I be concerned? The short answer, it depends.

If someone is, let’s say, a real estate flipper or wholesaler, someone who plays a contract assignment middleman or who relies on extremely short-term market performance to make a margin, can become very distressed during volatile or fluctuant rate markets. Depending upon how their debt structure and/or capital stack is assembled, rate volatility or fluctuation can wreak havoc on their business model. In the long-term, however, only time will tell.

Navigating through Q1 2022 and moving into Q2, the more seasonally active period of real estate markets, will give us as indication into two primary drivers of rate increases. First, the appetite of the Federal Reserve to continue its tapering policy and whether it also moves to rate tightening. The second, the federal government’s policy response to inflation.

Addressing the former, the Fed is likely to continue upon its adjusted timeline of tapering and then moving to rate tightening, both of which the market will do its best to price in and adjust for accordingly. From there, we also have a looming “unwinding” of its balance sheet to account for the ultimate sale of all securities it has accumulated, another source of excess supply which has yet to be formally addressed. This would be the Fed concluding its tapering and then moving to sell securities it is holding. Depending on the tapering response, this could be significant and meaningfully effect the market. Time, however, will be the determinant. The Fed may either thread the rate needle, which will result in minimal economic disruption, or move far too slow or too fast which results in either economic contraction or excessive overheating. The government’s response to inflation has the capacity to be just as productive or worrisome.

Congress is objectively useless. It is more likely that political infighting, finger pointing, and name calling will come out of our legislative branch than any reasonable policy measures addressing inflation, although I am a firm believer that markets are the best system to address and repair these problems, but natural market operation is just not our reality today. This leaves the executive branch, which has demonstrated a core belief in top-down centralized authority. One indication of its reaction trajectory can be seen with the inflation of meat pricing.

The administration is claiming that four big meat processors are responsible for meat inflation by profiteering and engaging in anticompetitive behaviors surrounding COVID-19 related supply chain issues. Side note, given the DOJ’s current meandering through the real estate industry under the auspice of antitrust behavior, fueled largely by claims of excess fees, I find this somewhat comical and government’s lacking a basic understanding of how its policies have fueled rapid asset appreciation and now inflation…but I digress.  

What the administration fails to address is that government unilaterally shut down both supply and demand mechanisms within our economy. Over the past two years, many businesses, merely to survive, have operated in as small a capacity as possible. When demand surges and capacity for supply is not in place due to that artificial constriction, prices will rise, and shortages will exist. Rather than unencumber markets to allow for a natural return to equilibrium, there is now consideration of price controls to lessen inflation. Generally, when either an executive or administrative body attempts to control pricing through executive edict, the artificial 2^nd, 3^rd, and 4^th order effects tend to break unknown areas of markets, which then require even greater centralization and more executive action. For those who are understanding of market operation, we see that bad things tend to happen when government tries to exert direct market controls rather than just set the rules of engagement. Many of us know someone with a small business who was affected by COVID lockdowns and business restrictions. Amazon, Wal-Mart, and Target were allowed to operate, but the corner sandwich shop was not. The sandwich shop lost and will likely never return. Wal-Mart, on the other hand, is doing just fine.

Hopefully, government will realize that it should let the market sort out these problems even if the market did not create the problems. If this happens, inflation will return to normal and rates, though they will rise, will not need to become Volker-esque to regain control of the market.

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