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Why higher interest rates are not bad news

10-yr Treasury yields (top chart) hit bottom last September (1.72%), and are now 66 bps higher (2.38%). Conforming 30-yr fixed mortgage rates hit bottom last December (3.94%) and are only marginally higher today (4.09%). There's a bit of a lag between the two, and the spread between 10-yr Treasuries and Fannie Mae collateral has compressed to about as tight as it's going to get. So the recent rise in 10-yr Treasury yields will almost surely result in a significant increase in conforming mortgage rates in the weeks and months to come. If the recent rise in Treasury yields holds, then the bottom chart is depicting what will prove to be the all-time low in mortgage rates.

If mortgage rates are headed higher, won't this slow or possibly halt the nascent housing market recovery? No, and here's why:

To begin with, Treasury yields and mortgage rates fell to historically low levels last fall primarily because a) the demand for safe-haven Treasuries and agency mortgages was intense, since the market fully expected the U.S. economy to fall into another recession, and b) the demand for home mortgages was historically weak, because potential homebuyers were fearful that prices would decline further. In short, the intense demand for safe-haven Treasuries and relatively safe mortgages coupled with the very weak demand for home mortgages resulted in a surfeit of loanable funds which, in turn, pushed interest rates to historically low levels.

Today's rising interest rates signal an important reversal in investor psychology and in the prospective health of the economy. Things are getting better, and the demand for safe-haven Treasuries is therefore declining. An improving economy should bolster the demand for mortgages, even as interest rates rise. Rising interest rates go hand in hand with an improving economy; higher interest rates don't weaken the economy, because they are a direct reflection of a stronger economy. Higher rates only become a threat to the economy when they are driven higher by tight monetary policy, but that is manifestly not the case today. Moreover, prospective homebuyers are likely to be encouraged to buy even as rates rise, because they will begin to see that it is better to buy now than to wait for rates to rise even more. At today's prices and even with substantially higher interest rates, housing is more affordable than ever before for the majority of households.

This chart comes from the National Assoc. of Realtors, and shows that a family earning the median income has about twice the amount needed to purchase a median-price home using conventional financing.

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