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Interest rates have been a hot topic over the last 6-9 months.  As rates have been increasing many buyers have become reluctant to purchase a home.  Below is a great read from Ryan Niles at Cornerstone Home Lending - 


One driver of interest rates is credit quality or risk of default. Even though underwriting can mitigate this, someone with worse credit quality has a higher chance of default. Investors will demand a higher rate of interest to compensate them for taking on the added risk of default due to poorer credit quality. 

The other and more important driver of interest rates is inflation. Inflation is the archenemy of Bonds since Bonds pay investors a fixed rate of return over time. 

Inflation erodes the buying power of your future fixed return because the cost of goods and services has increased. Meaning that fixed amount received will purchase less in the future. 

Example: You lend someone $100,000 at 4%. Your fixed rate interest only payment is $4,000 per year. Today that $4,000 can purchase a shopping list of goods and services. But over time, prices rise due to inflation so we can’t purchase all of the items on the shopping list with that same fixed amount received. If inflation were to accelerate, the only protection investors have is to increase interest rates so that they receive a larger fixed payment in order to offset the more rapid erosion of their buying power. 

But what is inflation? Inflation is too many dollars chasing too few products, which causes prices to be bid higher. If there is an item with high demand, such as a home on the market that has a lot of potential buyers, the high demand will drive the price of that home higher. 

Deflation is the opposite. Deflation is where there are too many products and not enough buyers, which drives prices lower. If you have 10 homes for sale on one block and only a handful of interested buyers, there are too many products competing for too few dollars. If you have a large inventory that is not moving, you tend to lower the price to increase demand, which contributes to deflation. 

If inflation is rising, Mortgage Bond investors must be compensated with a higher rate of return to combat the erosion of the Bond’s fixed payment, causing Mortgage Rates to rise. As a result, inflation reports are followed closely. 

As shown in the chart below, when duration increases, so does the sensitivity to inflation. The buying power of a $300,000 loan at 2% inflation is much less in year 10 than in year 7. 


If inflation were to rise from 2% to 3%, investors would see their buying power erode more rapidly over time. Notice the reduction in buying power after 7 years would drop from $886 to $833 due to the increase in inflation. Investors could offset this by increasing the rate from 4% to 4.25%, which would more closely approximate the same buying power they would have had in the lower inflation environment. 

As you go farther out in duration, inflation has a greater impact. After 10 years, the increase in inflation from 2% to 3% would require investors to receive a rate of return of 4.375% instead of 4% to have the same buying power as they would have had in a 2% inflation environment. 

Velocity of Money 

The Velocity of Money tells us how many times the same dollar turns over. Here is an example to help illustrate what is meant by “the same dollar turning over.” 

The money that a consumer spends to purchase a car will earn the salesperson, the dealership, and the manufacturer money. Then the salesperson goes out and uses this income to go to a restaurant. The restaurant owner can now use this income to purchase furniture, which the furniture store owner can then spend and so on. 

How does debt affect the velocity of money? Debt is used to bring a future purchase forward to today. Using the same example of a car, an individual can either save up to purchase a car with cash in the future or take out a loan to purchase that car today. If debt is used to make a purchase, it initially creates velocity of money, as we have just explained, but that debt now has future payments that must be made to service the debt. If the monthly payment to service the debt is $500 then the borrower would have $500 less each month to make future purchases, causing a drag on the economy, and slowing future velocity of money. 

However, if the purchase of the vehicle is used to generate income above and beyond the debt service, it can eliminate that drag and create additional velocity of money. If the individual uses the car to become an Uber driver, this debt will now generate income. If the income the person receives is about $2,000 per month, it will outweigh the debt payment of $500 and create additional velocity of money. 

Fixed Mortgage Rates vs. Treasury Yields 

Many people mistakenly think that Mortgage Rates and the 10-year Treasury are tied to one another. They are not. Overall, Mortgage Rates and 10-year Treasury Yields will likely move in the same direction most of the time...but not always. And more importantly, they will not move in lockstep. 







Posted by Rob Greer on
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