Interest rate spread
The interest rate spread between the yields of Treasury bonds (IEF) and mortgage rates (MBB) is the additional return demanded by investors for assuming higher risk. At a micro level, mortgage rates are primarily influenced by the credit profile of the borrower, and since most mortgages have pre-payment options, yields are also higher to compensate for pre-payment risk. Besides micro factors, mortgage rates are also influenced by macro factors, such as the supply and demand for mortgages, whether the economy is in an expansionary or a recessionary phase, monetary policies followed by the U.S. Federal Reserve, and inflation expectations.
Other factors remaining constant, mortgage interest rates are higher when:
- Demand for mortgages is higher
- The economy is expanding
- The general level of interest rates in the economy is higher
- Inflation expectations are higher
The interest rate spread is the difference between Treasury yields (TLH) and interest rates on mortgages (VMBS). Interest rate spreads tend to widen in times of economic uncertainty, when borrowers are perceived to have higher credit risk, and vice versa. Consumer cyclical sector (XLY) stocks are some of the most affected stocks in an economic upturn or downturn.
To learn more about spreads between Treasuries and mortgage rates, read on to Part 9 of this series.