Our first thought about interest rates during 2020 might have been that a shocking increase in uncertainty (risk) due to the emerging pandemic would lead to a significant increase in risk premiums bringing about higher rates. Well, that did not happen. Rather, investors moved to low-risk assets driving down the 10-Year Treasury Bond yield allowing mortgage rates to offer wider spreads at lower nominal rates.
It helps to see where the market stood before the discovery of COVID-19. Back in March of 2019, the U.S. Treasury yield curve inverted. What does this mean? An inverted yield curve shows that the yield on a 3-month Treasury bond rose above the yield on a 10-Year Treasury bond. For the first time since 2007, investors were earning a higher return on short-term securities than they were on long-term Treasuries. Typically, investors are compensated with a higher yield on long-term securities to account for the perceived inflationary risk in a long-term environment. As inflation rises, the value of an investment declines, showing why investors expect a higher return.
Figure 1 – Data provided by the Federal Reserve Bank of St. Louis
An inverted yield curve is a strong indicator of an impending recession. Typically, a recession follows a yield curve inversion by 8-24 months. According to data from Reuters, “the U.S. Treasury yield curve has inverted before each recession in the past 50 years and has only offered a false signal just once in that time.” While there can be many explanations of this inversion, it mainly boils down to investors’ expectations about the future growth potential of the market. If returns on short-term bonds are higher than those of long-term bonds, investors clearly do not feel confident about market growth in the long run.
Following the March 2019 inversion, the 10-Year Treasury yield fell for two consecutive quarters, as seen in the accompanying chart. After one stable quarter, apparent concern over the building pandemic information forced the Treasury yield to fall once again. The collection of different mortgage rates did not move lockstep with Treasuries but did follow their general direction during 2020. As the chart reveals, the spread between Treasuries and mortgage rates widened to reflect increasing uncertainty despite the mortgage rates’ declined over the year.
Most fixed and adjustable-rate mortgages are based on the comparable-term treasury rate with a spread anywhere between 100-350 basis points. After the yield curve inversion in March of 2019, the 10-Year Treasury yield continued to decline. This allowed residential mortgage rates to fall and offer increasing spreads at the same time.
How far the 10-year treasury will fall is a question that remains to be answered. It does rebound slightly in 2020Q4 but shows little sign of making a big jump to where it began in 2019.