What Do Mortgages Have To Do With Bond Yields?

by: Barry Ritholtz

That's the question that I've heard from a few readers and clients. Fortunately, the Ahead of the Tape column answered that exact question Friday:

"When Treasury yields rise, yields on bonds backed by mortgages tend to rise more. Higher mortgage rates make it less likely homeowners will either refinance their mortgage or buy a new home. Fewer prepayments mean mortgage investors risk holding more mortgages on their books than they expected. To counter that, they readjust by either selling mortgages or selling Treasuries as a hedge. Both of those things drive Treasury yields and mortgage rates higher -- and can push more mortgage investors to sell.

Until yesterday, many mortgage investors appear to have been sitting out the rise in rates. But economic strength and rising interest rates overseas in combination with a Federal Reserve that market participants see as increasingly unlikely to lower rates finally forced their hand.

Mortgage portfolios may be back in balance, which could stem the selling for now. But if rates stay high, many of the debt-financed transactions private-equity firms have been using to acquire companies will be a lot higher. At the same time, the recovery in the housing market that investors keep hoping for could get pushed back."

That's also an apt example of "reflexivity" -- George Soros' explanation for the impact a (relatively) small market action could have on the broader market.

Bond analysts have been looking for a rate cut because, as Marketbeat explained, "benchmark Treasuries rarely trade at a level below the federal-funds rate unless more rate cuts look imminent." Hence, that's the main reason many of the bond gurus were (incorrectly) looking for Fed Rate cuts.

Now that the "No imminent rate cuts" has actually penetrated the brain pans of Bond analysts and traders, we can expect a pretty straight run towards 5.25%.

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As an aside, when Jesse Eisinger was writing the Ahead of the Tape column, it was rumored to be one of the most read columns in the Journal (He's now ensconced at Conde Nast's Portfolio).

When Justin Lahart took over the column, he had some pretty big shoes to fill. He was doing a more-than-adequate job, but as of late, he really seems to be blossoming -- breaking out from a big base, even. Many of his recent columns have been so sharp, timely and dead on, that I find myself reading that column first -- before I even see what's one the front page. Friday's column is a perfect example.

Kudos !

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Sources:
Mortgage Jitters May Account For Bond Selloff
Justin Lahart
WSJ, June 8, 2007; Page C1
http://online.wsj.com/article/SB118126020057028477.html

Bonds Get Bashed
David Gaffen
WSJ Market Beat, June 8, 2007, 8:56 am
http://blogs.wsj.com/marketbeat/2007/06/08/bonds-get-bashed/