Mortgage Q&A: Inflation fears boost rates

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Mortgage rates shot up last week, mainly because of a sell-off in U.S. Treasury bonds. Thirty-year fixed-rate mortgages tend to follow the movement of the 10-year Treasury bond.

Why are treasury yields spiking? A couple of weeks ago, I wrote about the Fed’s implementation of “quantitative easing,” in which the Fed will buy enormous amounts of Treasury debt in hopes of creating a demand for Treasury bonds. This demand normally would increase the price of the treasuries and lower yields, which would keep interest rates low or even make them fall further.

Since the announcement of the second round of quantitative easing, dubbed QEII, the yield on the 10- year Treasury bond has risen from about 2.50 percent to 3.25 percent. Mortgage rates, in turn, have risen by almost a full percentage point.

Did the Fed’s QEII plan backfire? I’m afraid it may have. Chairman Ben S. Bernanke has made no secret of his belief that the market’s fear of inflation is “overstated.” Unfortunately, the market doesn’t appear to believe Ben.

The market fears QEII will spark inflation, and the value of long-term instruments, such as Treasury bonds and mortgage backed securities, erodes during periods of inflation. This is one reason interest rates have risen.

Other factors have played a role in the most recent bond sell-off. A slew of economic news contributed to the rise in rates. Recent reports of consumer confidence, durable goods orders and jobless claims all came in better than expected. Good news on the economic front indicates a strengthening economy, which further sparks fears of inflation.

The most recent event that caused rates to rise was the surprising tax compromise between the White House and Republican lawmakers. The bill is not only expected to fuel consumer spending and economic growth, but also to increase the federal deficit, adding to the inflation concern.

On the other hand, markets, economists and analysts have been very wrong before in predicting the direction of the economy. I don’t believe anyone predicted inflation would be so tame today, more than a year after the federal government’s $800 billion bailout of Wall Street and Detroit.

Earlier this year, I read a quote from the chief economist of a large U.S. bank who predicted the yield on the 10-year Treasury bond would fall to 2 percent by the end of 2010 and reach 1.75 percent by the end of the first quarter of 2011. He’s been dead wrong so far.

Meanwhile, mortgage interest rates are still low. With little or no fees, 30-year fixed rates are still below 5 percent, 15-year fixed rates are below 4.50 percent and seven- and five-year adjustables are hovering around 4 percent.

Send e-mail to henrysavage@pmcmortgage.com.

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