What Does China Have to Do With Recent Changes in U.S. Mortgage Rates?

We've recently observed the Federal Reserve raising short-term interest rates while the 10-year Treasury hardly changed. Inflation expectations are low, but suddenly 10-year Treasuries climbed to a 10-month high and mortgage rates jumped as well. Why the sudden shift when inflation expectations have barely altered? What does China have to do with the recent move in U.S. mortgage rates?

First, it is important to recall the Federal Reserve does not control interest rates, but merely influences short-term rates based on federal funds rates. 

Long-term rates (10-year Treasuries) are market driven.

There are two primary drivers of long-term rates: 

1. INFLATION EXPECTATIONS

One of the major drivers Treasury pricing is driven by forward-looking expectations on inflation. Is the economy going to grow and are prices going to rise? As inflation increases, the yields on Treasuries also increase. Currently, there is some talk of future inflation, but it has been muted by low commodity prices and labor costs that continue to stagnate. 

2. MARKET FORCES

This refers to basic supply and demand. Demand is driven by investors in the U.S. along with investors abroad and nations that park money in U.S. Treasuries due to the safety and liquidity. The biggest demand is from international investors like China. The demand for Treasuries has increased prices and therefore kept yields (rates) at historic lows. On the flip side is supply. The more supply of Treasuries, the lower the price and the higher the yield (remember: they move in opposite directions). The borrowing needs of the U.S. will continue to grow with deficit spending. The non-partisan congressional office (CBO) has confirmed this as well with deficits predicted to swell in the coming years. 

• SUPPLY: The supply of Treasuries will continue to grow rapidly as the government continues deficit spending and reducing their balance sheet of assets that were purchased in the last recession. The U.S. posted its largest budget deficit since 2013 in the fiscal year that just ended on Sept. 30, and most economists predict President Donald Trump’s tax-reform plan will worsen deficits. The bigger budget shortfalls they foresee would add to the more than $10 trillion rise in federal debt over the next decade that the Congressional Budget Office is already forecasting. Treasury issuance would continue to rise as the budget shortfall increases. In a nutshell, supply will continue to increase which will drive prices down and yields up.
• DEMAND: According to a recent article in Bloomberg: "Senior government officials in Beijing reviewing the nation's foreign-exchange holdings have recommended slowing or halting purchases of U.S. Treasuries, according to people familiar with the matter." China is the largest buyer of U.S. Treasuries and therefore any major pullback from purchases willd drop the demand of U.S. Treasuries. From economics 101, a drop in demand usually means prices will come down as well. This will laed to higher yields and ultimately higher interest rates.

WHAT'S CHINA HAVE TO DO WITH IT?

China is the largest buyer/holder of U.S. Treasuries with an estimated $1.15 trillion. This gives China the ability to "influence" Treasury prices. For example, if all the sudden China started divesting Treasuries this would push the price down and yields up. There is speculation that China is selling Treasuries now due to the "trade spat" with the current administration. China's influence will only worsen as deficits increase.

HOW DOES THE TAX PLAN INFLUENCE RATES?

According to the Congressional Budget Office, deficits will continue to grow due to the recent tax plan and increased cost of entitlement programs (Social Security, Medicare, Medicaid, etc.) As supply of Treasuries increase rates will continue to surge and purchasers will require higher rates of return.

WHAT ARE THE LONG-TERM IMPACTS ON RATES/MORTGAGES?

A sharp increase in long-term rates is not good for the economy. Long-term Treasuries are the primary driver of both commercial and residential mortgages along with other longer term securities. The recent increase in rates will slow purchases and refinancing on the commercial and residential side.

THE ECONOMY COULD BE IN FOR A WILD RIDE

It doesn't look like the deficit is going to do anything other than grow in the future. This reliance on deficit spending makes the U.S. economy more prone to spikes in rates as we are seeing today. The deficits also increase our reliance on other countries and investors to continue financing our budget. This opens the door for nations, such as China, to have an active say in the American economy by either buying or selling Treasuries to manipulate interest rates for their own gains.

So, are you ready for your residential and commercial mortgage rates to be controlled by a foreign country?