Have you ever purchased anything at an auction? Love them or hate them, in a free-market economy auctions are a very efficient way of establishing the value of items like livestock, art, foreclosures, automobiles, or… bonds. And in this last instance, since the price and yields of risk-free Treasury bills, notes, and bonds directly impact the price and yields of securities backed by mortgages, it is good to at least have a basic knowledge of what is going on “behind the scenes” and how mortgage prices are influenced by Treasury auctions.
The U.S. government’s activities are financed through a variety of methods, including tax collections, tariffs, and issuing (selling) debt. Buying debt from the U.S. government is the same as loaning it money: I will give you money now, and you will give it back later with interest. The government primarily sells debt through auctions, and Treasury auctions have turned into quite a hot topic lately. Analysts, economists, and investors carefully monitor the supply and demand of Treasury debt for an indication of the overall market, and the constantly changing landscape influences the price of mortgage debt and therefore the rates borrowers see.
As every lender knows, interest rates have increased over the last 12 to 18 months, impacting the affordability of housing, and driving volumes down. As rates rise, so do Treasury yields—coupons on newly issued debt which increases the expense burden on the federal government and our budget shortfall persists—as well as mortgage rates.
The sizes of these Treasury auctions have increased, unusual for a period when we’re not in a crisis, like financing a war. Additionally, the appetite for newly issued Treasurys has been waning due to a few large buyers exiting the scene. Historically there were three big buyers of U.S. Treasury securities: the Federal Reserve, Japan, and China. But all three of these big buyers have reduced their purchases, and in some instances turned into net sellers of Treasurys. This tends to move prices lower and rates higher, including mortgage rates. The increased supply and the decreased demand show up in the auction results and have been sending “tremors” across bond and equity markets, and in mortgage rates.
During the pandemic, our Federal Reserve stepped in and purchased securities, including mortgage-backed securities, driving up fixed-income prices and driving down yields. As the pandemic wound down, this was no longer needed. A big reason for the Fed turning into a net seller of Treasurys was its quantitative tightening program, intended to reduce the size of the Fed’s balance sheet and fight inflation, which began in mid-2022.
This shift from quantitative easing to quantitative tightening had been well-telegraphed, and ended up being part of the catalyst that drove Treasury yields higher into the summer of 2022, with the 10-year yield rising to 3.47 percent from .55 percent in the summer of 2020. The Federal Reserve is no longer acting as a net buyer. This happened at the same time as other traditional big buyers stopped buying, tending to push prices down and yields higher.
Not only that, the amount of debt the United States has needed to issue/sell/auction has risen. The increasing amount of debt that needs to be absorbed without the traditional buyers absorbing it is worrisome, but not terrible. Primary dealers exist, in part, to contractually step in and buy whatever securities are not purchased during the auction by other buyers: whatever isn’t bought by other bidders in a Treasury auction must be absorbed by primary dealers. Because there has been less demand from other buyers, such as foreign governments, the primary dealers have had to absorb an increasing amount of issuance.
As with any bond, including those backed by mortgages, if the buying appetite is low, prices drop, and yields move higher. But as we enter the final month of 2023, we enter a period of falling inflation, rate cuts in 2024 being priced in, and an equity rally driven largely by the swift drop in Treasury yields since mid-October.
If the demand during Treasury auctions continues to become weaker and weaker, it could serve as a catalyst for yields to rise again. If yields go higher, so does the U.S. interest expense as well as interest rates on mortgages. According to the Congressional Budget Office, net interest expense as a percent of Gross Domestic Product is already projected to grow rapidly over the next few decades.
To be clear, nothing bad has happened yet, and supply and demand always tend to equalize. There is a school of thought that nothing ever will, however, because so far, although the auctions have been met with weaker demand, they’re still getting done. And the U.S. is still the most credit-worthy country in the world, so a default or material deterioration seems highly unlikely, not to mention politically unsavory.
Certainly, the traditional investors in mortgage-backed securities, like insurance companies and pension funds, are very focused on supply and demand trends. For lenders focused on mortgage rates, which in turn tend to follow interest rate trends in the Treasury market, knowing the patterns in supply and demand are helpful: if there is no demand for what a lender is producing, there is no use in producing it.
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