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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
Gianluca Moretti
Fixed Income Economist
UBS Global Asset Management
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
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