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Economist InsightsMoving out

10 June 2013Asset management

In the old, simpler, days of monetary policy, central

banks used to target the short-term interest rate and

hope that the rest of the yield curve would affect theeconomy through borrowing costs. Once rates started to

push against the lower bound, some central banks used

quantitative easing (QE) to target the whole yield curve. The

Federal Reserve went one step further by buying mortgage

backed securities, directly targeting the borrowing costs for

US households. Numerous speeches by Fed officials have

demonstrated the importance that they place on a recovery

in the housing market. After the large post-crisis correction

in the residential sector, such a recovery should help put the

US economy on a more robust growth path. Since the Fed

is effectively targeting the mortgage rate, how will it react to

the recent spike up in US mortgage rates?

Arguably the Fed brought this increase in mortgage rates

on itself. As soon as Chairman Bernanke mentioned the

possibility of an earlier tapering of bond purchases, the

US Treasury market sold off. This has knock-on effects

on mortgage rates, which are generally a spread above

Treasuries. Although the reasons are different, the

movement is actually very similar in size and speed to the

market reaction to the second round of QE in 2010 (see

chart 1). Unlike QE1 and QE3, in QE2 the Fed only bought

Treasuries. The economy was also weakening (which is why

the Fed did more QE) and house prices had started to fall

again. The combination of these factors pushed up interestrates on mortgages.

Joshua McCallum

Senior Fixed Income Economist

UBS Global Asset Management

joshua.mccallum@ubs.com

Gianluca Moretti

Fixed Income Economist

UBS Global Asset Management

gianluca.moretti@ubs.com

Chart 1: Exit velocities

Yield on 30y US Treasuries (UST) and interest rate on 30y fixed rate

mortgages (FRM), %

Source: Bankrate.com, Bloomberg

3

4

5

6

May2011

Apr2011

Mar2011

Feb2011

Jan2011

Dec2010

Nov2010

Oct2010

Sep2010

Aug2010

2

3

4

5

30y FRM30y UST

Oct2013

Sep2013

Aug2013

Jul2013

Jun2013

May2013

Apr2013

Mar2013

Feb2013

a. From 9 August 2010

b. From 23 February 2013

The Federal Reserve has placed great importance on a

recovery in the US housing market and its latest quantitative

easing round directly targeted household borrowing costs.

But US mortgage rates have recently spiked up, partly in

reaction to speculation that the Fed would taper its QE3 bond

purchases earlier than previously thought. The US housingmarket has been strong lately, but there is still a fear that

the mortgage rate spike might dampen the recovery. Luckily

the fundamentals of demand are much stronger than in the

past. And as house prices are still over 25% below the pre-crisis

peak, while personal income per capita is over 5% above

its pre-crisis peak, it would take a significant mortgage rate

increase to make housing unaffordable.

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The US economy is clearly further along in its recovery than

it was in 2010 which makes exit talk more credible, but on

the other hand, tapering of QE purchases would just mean a

slowing in the rate of monetary easing several steps away

from tightening. When you are thinking about a 30-year

bond, the question of whether tapering of QE starts a few

months earlier or later should not really make a difference,

but it does shift the market. Arguably, much of the recent

increase in yields could be seen as a reversal of the decrease

in yields that followed signals from the Fed earlier this year

that the amount of QE could go up as well as down.

Whatever the reasons, mortgage rates have spiked upwards

and this will be felt by people who were looking to take out

mortgages. The US housing market has been strong lately,

posting double digit house price increases on the year, but

there is still a fear that the improvement could turn out to be

fragile. Luckily enough, this concern is likely to be overstated

simply because the fundamentals of demand are so much

stronger than in the past.

One indicator of the fundamental strength of demand isthe affordability index. This looks at the ability of a median

income household to buy a median price home. Affordability

fell during the housing boom years as people took on ever-

larger mortgages, but since the crash, a collapse in house

prices and mortgage interest rates has sent affordability up

to new highs (see chart 2). So even if people were unwilling

to buy houses because they feared further price drops, and

even if banks were unwilling to lend money for fear of future

unemployment and capital requirements, affordability was

not holding back the market.

An increase in mortgage rates of half a percentage pointis not going to have a huge impact on the affordability

index. Such an increase is likely to push the index down

slightly, but it will still remain well above the pre-bubble

average. If anything is going to be pushing the affordability

index, it will be rapid growth in house prices that starts to

outstrip the increase in household incomes. This may make

the market less affordable, but is hardly a sign for concern.

It would be a sign of strength if strong affordability

encourages borrowing (and the banks lend more), which

would act to reduce affordability.

The increase in yield is probably of most interest to investors

in mortgage backed securities (MBS). People may take

out 30-year fixed rate mortgages, but they do not tend

to hold them for that long. Firstly, the average amount of

time that a household stays in a home is about seven yearsor so, and that generally means having to take out a new

mortgage. Secondly, when mortgage rates fall households

tend to refinance in order to lock in the lower rates. For an

MBS holder, this means that they see pre-payments of the

mortgages, which effectively makes the maturity of their

MBS shorter. However, as rates rise, households are not

usually interested in refinancing in order to pay a higher rate,

so there are fewer pre-payments. Owners of MBS then find

that the expected maturity of their security will lengthen. In

short, they may find that they are now effectively lending

money for longer than they thought they were originally. In

some cases, that will encourage MBS investors to sell some of

their bonds to reduce their duration risk.

If the Fed also decides to taper earlier, as some in the market

expect, there could be even more upward pressure on

mortgage rates. But given that house prices are still over 25%

below the pre-crisis peak, while personal income per capita is

over 5% above its pre-crisis peak, it would take a significant

mortgage rate increase to make housing unaffordable. The

housing market fell so far that it has a lot of room to run

before it hits any constraints.

The views expressed are as of June 2013 and are a general guide to the views of UBS Global Asset Management. This document does not replace portfolio and fund-specific materials. Commentary is at a macro or strategy level and is not with reference to any registered or other mutual fund. This document is intended forlimited distribution to the clients and associates of UBS Global Asset Management. Use or distribution by any other person is prohibited. Copying any part of this publicationwithout the written permission of UBS Global Asset Management is prohibited. Care has been taken to ensure the accuracy of its content but no responsibility is acceptedfor any errors or omissions herein. Please note that past performance is not a guide to the future. Potential for profit is accompanied by the possibility of loss. The value ofinvestments and the income from them may go down as well as up and investors may not get back the original amount invested. This document is a marketing communication.Any market or investment views expressed are not intended to be investment research. The document has not been prepared in line with the requirements of any jurisdictiondesigned to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. Theinformation contained in this document does not constitute a distribution, nor should it be considered a recommendation to purchase or sell any particular security or fund.The information and opinions contained in this document have been compiled or arrived at based upon information obtained from sources believed to be reliable and in goodfaith. All such information and opinions are subject to change without notice. A number of the comments in this document are based on current expectations and are consideredforward-looking statements. Actual future results, however, may prove to be different from expectations. The opinions expressed are a reflection of UBS Global AssetManagements best judgment at the time this document is compiled and any obligation to update or alter forward-looking statements as a result of new information, futureevents, or otherwise is disclaimed. Furthermore, these views are not intended to predict or guarantee the future performance of any individual security, asset class, marketsgenerally, nor are they intended to predict the future performance of any UBS Global Asset Management account, portfolio or fund. UBS 2013. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

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Chart 2: Afordable

US housing affordability index (100 denotes that the median

household has just enough income to afford a mortgage on the

median priced home)

Source: National Association of Realtors

50

100

150

200

250

201120062001199619911986198119761971

morea

ffordable