Interest rate spreads

The interest rate spread between ten-year Treasury securities (IEF) and 30-year conventional mortgages (VMBS) was at historic highs at the end of 2008 and the beginning of 2009, as there were sharp declines in Treasury rates. Yields on the ten-year Treasury note fell below the 3% level for the first time in history. Mortgage rates, however, didn’t fall as sharply, despite the U.S. government’s bailout of Fannie Mae and Freddie Mac. This caused the spread between ten-year Treasury notes and 30-year conventional mortgages to widen to historically high levels.

Why Treasury and mortgage rate spreads hit historic highs

Since the beginning of 2013 to year-to-date 2014, the spread has averaged 1.62%, which is in line with historical averages. This is because both Treasury bonds and mortgage rates have stayed low, compared to historical levels, because of the Fed’s accommodative monetary stance and flight-to-safety flows from emerging markets (EEM) and frontier markets, which have more than compensated for the decrease in monthly purchases by the U.S. Federal Reserve.

Last week, the spread between ten-year T-Bond yields (IEF) and 30-year conventional mortgages (MBB) was about 171 basis points (or bps), increasing by 14 basis points (or bps) from the previous week, as yields on ten-year bonds declined five basis points to 2.66% on increased flight-to-safety flows to U.S. Treasuries on the uncertain situation in Ukraine. The 30-year conventional mortgage rate increased 9 basis points to 4.37% for the week ending on March 13, due to better-than-expected job creation numbers released by the Bureau of Labor Statistics on Friday, March 7. The increase in non-farm payrolls for the month of February was estimated at 175,000—higher than January’s revised figure of 129,000. An increase in job creation or employment would imply, other factors remaining constant, that the housing sector (ITB) will benefit, as improved consumer confidence would spur more people to buy new homes, increasing demand for housing and raising rates.

Economic indicators that show the economy is recovering will impact both Treasuries and mortgage rates. Other factors remaining constant, if the economy is on the road to recovery, the Fed should start easing off its monetary stimulus policies that bring about low rates in order to stimulate a recovery. This will raise interest rates across the fixed income spectrum, increasing mortgage rates as well.

To learn more about investing in fixed income securities, see the Market Realist series Why international tensions offset domestic economic growth.

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