Inflation-Adjusted Yields Surge. Mortgage Rates March North Of 8% In October.

Technical factors have overwhelmed fundamentals in multiple corners of the bond market as 2023 has progressed. This phenomenon is perhaps most visible in the $25 trillion U.S. Treasury securities market, where supply and demand imbalances have helped fuel a surge in intermediate and long-end yields during the past several months. Some of the move can be attributed to an improved economic outlook feeding the “higher for longer” narrative, but real, or inflation-adjusted, yields are up sharply as well.

Exhibit 1 tracks 5-year and 10-year Treasury Inflation Protected Securities (TIPS) yields so far this year. Although some critics argue the TIPS market doesn’t fully or accurately capture market inflation expectations, yields have clearly risen beyond what can be explained by a higher forward path of short-term rates after the regional bank scare last spring.

This has coincided with a significant increase in Treasury funding needs (supply), driven by both increased budget deficits and the Fed’s Quantitative Tightening (QT) efforts, the latter of which is effectively adding more than $700 billion per year to the supply/demand imbalance. A popular explanation for the recent sell-off in long-end Treasury yields is expectations for a higher and more persistent fiscal budget deficit. Some have suggested a return of the “bond vigilantes” made famous in the 1990s during the Clinton administration.

A technical imbalance exists in another large sector — Agency MBS. For the past 15 years, the largest sponsors of this asset class have been the Fed and financial institutions. Both buying segments have been sidelined for the past 18 months for differing reasons. Although surging interest rate volatility also has been a prime contributor to the spread widening during that timeframe, other investors — for example, money managers — haven’t been able to pick up the slack even while shifting to overweight MBS positions in recent months.

This could limit future spread tightening if QT and current liquidity conditions for financial institutions persist. However, current valuations and yield carry remain very attractive on a historical basis, more specifically for current/recent production coupons.

The sell-off in long-end yields during the past six months has pushed mortgage rates north of 8% for the first time since 2000, according to BankRate’s national average of 30-year conventional loans. With home prices remaining stubbornly high, thanks in large part to a dearth of supply, housing affordability measures are the worst we’ve seen in many years.

Exhibit 2 tracks the National Association of Realtors’ housing affordability composite index, which began in the first quarter of 1986. The most recent second quarter data shows affordability at the lowest level on record. With mortgage rates continuing to rise in the third quarter, affordability has only worsened.

Visit ALM First to read about the latest economic data and overall market trends in the November 2023 Market Commentary.

Jason Haley joined ALM First in 2008 and is the firm’s chief investment officer. He heads ALM First’s Investment Management Group (IMG), which is responsible for leading the investment process and investment theme development. Haley also oversees all capital markets activities, including portfolio management, trading, market research and commentary, and execution of hedging and funding strategies for the firm’s depository clients. He holds an MBA with a concentration in finance and a BBA with a concentration in marketing, both from The University of Mississippi.