Contract rates on mortgages used to purchase newly built homes fell by 9 basis points over the month of July 2017. According to the Federal Housing Finance Agency, contract rates settled at 3.94 percent in July. In June, contract rates were 4.03 percent. After rising to 4.18 percent in February 2017, an increase of 64 basis points from the October 2016 low of 3.54 percent, rates have fallen 24 basis points in subsequent months.
A previous post decomposed the mortgage rate into the yield on the 3-month Treasury bill, the yield curve, estimated as the spread between the rate on the 10-year Treasury note and the 3-month Treasury bill, and the mortgage risk premium, calculated as the spread between the mortgage contract rate and the rate on the 10-year Treasury note. The compartmentalization of mortgage rates illustrated that while the rise in mortgage rates partly reflected an increase in the 3-month Treasury bill rate, reflecting the Federal Open Market Committee’s decision to raise the federal funds rate in December 2016, the spread between the rate on the 3-month Treasury bill and 10-year Treasury note rate widened even more. Alternatively, the yield curve steepened. Meanwhile the mortgage risk premium fell by 2 basis points.
The decline in mortgage rates since February largely reflects the flattening of the yield curve. Since February, the rate on the 3-month Treasury bill has risen 56 basis points largely reflecting the two 25 basis point increases by the FOMC, one in each of March and June respectively. At the same time, the yield curve has flattened as the spread between the rate on the 10-Year Treasury note and the 3-month Treasury bill rate has shrunk by 66 basis points. To a lesser degree, the mortgage risk premium has also declined, falling by 14 basis points since February.
A previous post demonstrated how information contained in the Senior Loan Officer Opinion Survey (SLOOS) can predict a recession’s onset. The yield curve can also provide similar information. Important research by Arturo Estrella and Frederic Mishkin established the predictive power of the yield curve to forecast a recession four quarters away.
The economists explain that one reason why the yield curve is a valuable forecasting tool is because “a rise in the short-rate tends to flatten the yield curve as well as to slow real growth in the near term.” The current increase in the 3-month Treasury bill reflects actions taken by the FOMC in response to a stronger economic performance. Non-price loan terms (e.g. lending standards) notwithstanding, a higher price on 3-month Treasury bills tends to shrink demand for those loans, slowing the pace of economic activity that these loans are used to finance.
The rate on the 10-Year Treasury note represents financial market participants’ expectations about the future of the U.S. economy. As the economists note, “expectations of future inflation and real interest rates contained in the yield curve spread also seem to play an important role in the prediction of economic activity.” This is because “the expected real rate may be associated with expectations of future monetary policy and hence of future real growth. Moreover, because inflation tends to be positively related to activity, the expected inflation component may also be informative about future growth.” Previous NAHB analysis confirmed that the decline the 10-Year Treasury note rate between February and May 2017 reflected a slowdown in inflation expectations.
In its simplest interpretation, when the rate on the 3-month Treasury bill is below the 10-Year Treasury note rate (i.e. a normal yield curve), financial market participants are conveying that they believe the economy’s performance in the longer-run is going to be stronger than in the short-term, because of greater “real” growth, higher inflation, or a combination of these two dynamics. In contrast, when the rate on the 3-month Treasury bill exceeds the rate on the 10-Year Treasury note (i.e. an inverted yield curve), financial market participants convey the belief that the economy’s performance in the short-run will exceed its performance in the longer term which implies that a recession is imminent.
According to the figure above and consistent with research findings cited earlier, recessions typically occur approximately 4 quarters after the spread falls below zero and the yield curve is inverted. As a result, the yield curve is a relatively accurate predictor of a recession’s onset. More recently the spread between the two rates has been on a declining trend since 2010 indicating that the yield curve is flattening. However, the spread between the two rates is approximately 120 basis points, still more than 100 basis points away from zero. According to the Federal Reserve Bank of New York’s recession probability estimator, which transforms the yield curve into a recession likelihood estimation, there is a 9.5 percent probability of a recession over the ensuing 4 quarters.