Curves and Spreads

The events of the last year have precipitated two interesting scenarios.

The first is called the treasury yield curve. In normal times, short term interest rates are lower than long term rates. That’s because investors require a rate premium to lock their money in for a longer period of time. If one plots the time period (1 month, 6 months, 1 year, etc.) on the “x” axis of a graph, and the corresponding treasury security rate on the “y” axis of the same graph, the result is the yield curve.

A normal yield curve is upward sloping. On average, the normal slope is considered to be about 3% from the shortest to the longest term rates.

From 1927 to 2006, there were only 8 years when the average weekly yield curve status was inverted for the year: 1927, 1928, 1929, 1966, 1969, 1980, and 1981.

Most of those inverted years were associated with tough economic times. It is generally held that a prolonged inverted yield curve produces a subsequent recession.

Now here’s some interesting data about the yield curve over the last 12 months. For this purpose, I’ll look at it for treasury notes and bonds with maturities from 6 months to 10 years. One year ago, that yield curve was relatively flat at .39%. Six months ago it had steepened to 2.13%. On the last day of October 2008, it had steepened even further to 3.07%.

The steepening of the yield curve is the likely result of intentional loosening of the money supply by the Federal Reserve, lowering of the target rate for federal funds and lowering the discount rate charged to banks for borrowing from the Federal Reserve. A steep, positive yield curve is usually good for the economy. When created by significant government intervention such as we have recently seen, it can also be inflationary and lead to higher long term interest rates. The Federal Reserve has “pulled out the stops” to heal the economy, and must be vigilant in their control of inflation. In recent years, the Federal Reserve has precipitated higher short term interest rates to control inflationary pressure. And that causes the slope of the yield curve to flatten out.

The second phenomenon is the spread between mortgage rates and the comparable treasury security. Mortgages trade at a spread to the treasury security with comparable term.

As noted in a previous posting, thirty year mortgages have an average life about 10 years. Therefore, they are usually related to the ten year Treasury bond. In October of 2007, mortgages averaged about 1.85% above the 10 year Treasury. Six months ago, that had widened to about 2.25%. At the end of October, it had widened even more to near 2.5%.

That means that homeowners are paying relatively more for mortgage financing than they had to pay only one year ago. The 10 year treasury rate has dropped almost .5%. The thirty year mortgage rate is about the same as it was a year ago.

As a result of the Treasury Department takeover of Fannie and Freddie, securities issued by those two entities have the implicit guarantee of the government. Why then should Fannie and Freddie mortgage backed securities, and the underlying mortgages, trade at such a wide spread to Treasury securities?

It is likely that the spreads between the two will narrow as uncertainty diminishes. And that will be good for mortgage rates. Uncertainty has caused mortgage security investors to demand a higher spread versus Treasury securities. That spread will probably narrow as confidence improves. Even if Treasury rates go up a bit, the mortgage rate that we pay could remain the same. If rates go down at the same time the spread narrows, the resulting mortgage rate drop could become even more favorable.

It’s a good time to buy a home. Rates are attractive and housing prices are depressed. The steep yield curve is likely to precipitate economic recovery. Once housing inventory is absorbed – and it will be – we will see housing prices again increase.