Worries about the European debt crisis have investors flocking to relatively safe investments like mortgage-backed securities that are backed by the government, helping keep mortgage rates low.

But economists with the Mortgage Bankers Association still think rates on 30-year fixed-rate mortgages are likely to rise into the high 6 percent range by the end of 2012, albeit on a more gradual slope than previously projected.

In a June 11 forecast, MBA economists predict rates on 30-year fixed-rate mortgages will gradually rise to 5.4 percent during the fourth quarter of this year, reaching 6 percent in the last three months of 2011 and averaging 6.6 percent in the fourth quarter of 2012.

Worries about the European debt crisis have investors flocking to relatively safe investments like mortgage-backed securities that are backed by the government, helping keep mortgage rates low.

But economists with the Mortgage Bankers Association still think rates on 30-year fixed-rate mortgages are likely to rise into the high 6 percent range by the end of 2012, albeit on a more gradual slope than previously projected.

In a June 11 forecast, MBA economists predict rates on 30-year fixed-rate mortgages will gradually rise to 5.4 percent during the fourth quarter of this year, reaching 6 percent in the last three months of 2011 and averaging 6.6 percent in the fourth quarter of 2012.

In a previous May 12 forecast, MBA economists predicted the same endpoint — rates averaging 6.6 percent by the fourth quarter of 2012 — but with more of the increase coming sooner rather than later. The previous forecast projected rates on 30-year fixed-rate mortgages would hit 5.6 percent in the final three months of 2010 and 6.3 percent in the fourth quarter of 2011.

In commentary released in conjunction with the forecast, MBA economists said the European debt crisis "continues to chill markets around the globe." Fears about financial institutions’ exposure to sovereign debt have led to wider spreads between short-term rates like LIBOR (the London interbank offer rate) and Treasurys as banks restrict lending among themselves.

While spreads remain relatively low compared to the fall of 2008, signs of stress in financial markets, coupled with May’s weak job market report, "indicate that we are not out of the woods yet," MBA economists said. "The economy is growing, the recovery has begun, but markets, including the housing market, remain fragile, and susceptible to further stumbles if consumer and investor confidence continue to wane."

Given the gloomier macroeconomic outlook, the MBA does not expect national home prices to bottom until the end of next year, before seeing "some stabilization" in 2012. MBA economists expect to see greater differentiation in markets, with the strongest markets showing increases in prices this year.

If history is any indication, the Federal Reserve may wait until 2012 before it begins selling off its vast holdings of mortgage-backed securities and raising short-term interest rates, according to an analysis by a researcher at the Federal Reserve Bank of San Francisco. Either move could put upward pressure on mortgage rates.

Glenn Rudebusch, senior vice president and associate director of research at the Federal Reserve Bank of San Francisco, said that in the past the Fed has lowered the federal funds overnight rate by almost 2 percentage points for each 1 percentage point increase in the unemployment rate.

The federal funds rate has also come down by 1.3 percentage points for each 1 percentage point decrease in inflation.

Had the Fed been able to follow this rule of thumb during the financial crisis and recession, it would have lowered the federal funds rate to -5 percent, Rudebusch said. Since it could not take the federal funds rate into negative territory, the Fed took the unconventional step of buying up mortgage-backed securities and Treasurys to lower long-term interest rates.

Before ending the program in March, the Federal Reserve bought up $1.25 trillion in mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac, a move credited with helping keep mortgage rates near record lows.

Those unconventional purchases had a stimulus effect equivalent to an additional 1.5 to 3 percent reduction in the federal funds rate. As long as the Fed is holding onto those investments, it will likely be 2012 before unemployment decreases and inflation increases enough to the point where the federal funds rate would be back in equilibrium.

At that point, the Fed would be likely to respond to further inflationary pressure by increasing the federal funds rate, selling some of its mortgage-backed securities and Treasurys, or a combination of both, Rudebusch said.

He noted that a majority of the Federal Open Market Committee is on record as preferring to begin asset sales "some time after the first increase in the FOMC’s target for short-term interest rates."

Some analysts worry that holding short-term interest rates near zero for much longer could encourage excessive leverage and speculation, leading to asset bubbles.

But Rudebusch notes that because the federal funds target rate is already at zero, it would be hard to reverse course if the Fed tightened too soon.

On the other hand, he said, if signs of inflation do emerge the Fed could adjust the pace at which it increases the federal funds rate and sells off its securities holdings as needed in order to respond to a faster or slower recovery.

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