In economics, a person often has to follow or compose a string of logic. Any weak link in the chain often ruins the whole overarching thesis. Specifically, there will be a lot of “if blank goes up/down, then blank goes up/down” kinds of statements. They’re a little difficult to follow sometimes, but bear with me.

The following bloviation has a purpose; namely, that mortgage rates might be heading up from their record lows. If this happens, homeowners who are scrambling to refinance at a lower rate, may be out of luck. After much of the private sector has experienced a pay cut, people are trying to cut their living expenses accordingly. Whether a refinance will help someone stay in their home and avoid foreclosure, continue to afford health insurance or pay for daycare, higher mortgage rates impact the everyday person considerably. Those that still have an adjustable rate mortgage (ARM) poised to readjust this year, should be particularly concerned. The ARM’s still outstanding will be a new wave of foreclosures for the economy to deal with. But the biggest risk of all from increasing mortgage rates is the relationship between U.S. Treasury bonds and the government’s philosophy of stimulus/bailout to save the economy. Stay tuned…

As the price of Treasuries decreases, the interest rate on these bonds increases. Think of a bank offering an interest rate return on a certificate of deposit (CD). If bank depositors aren’t biting at the current rate, the bank must increase the interest rate on the CD to entice people. The same principle is occurring in the Treasuries market. Year-to-date, 30-year bonds are off 25% in price; 10-year bonds off 9%. Prices retreat when people don’t want to buy, or demand decreases. Remember, Treasury bonds are how the government borrows money from your grandmother, China and mutual funds. With bank bailouts, stimulus spending and a record budget deficit of about $2 trillion to fund, the government needs to raise some quick cash.

To do so, the Treasury has been auctioning off bonds over the last few weeks. This week alone, they’ve accumulated $101 billion of debt in the form of 2-year, 5-year and 7-year notes. China no longer buys 30-year notes from the U.S. because they’re genuinely concerned about America’s long-term ability to pay off debts. For China, investing in the United States is more a game of when they’ll get their money back, as opposed to what kind of a return they’ll earn in the process. China will likely continue to ratchet down the amount of U.S. debt they buy. (1)

The 10-year bond is a benchmark for mortgages and other lines of credit. Mortgage rates are based on 10-year Treasuries and out. The 10-year spiked to its highest level in six months yesterday. The bond market recovered a bit Thursday, once enough people showed up to buy the auctioned off Treasury debt, but will there be a demand for U.S. government debt forever? (2)

Goldman Sachs estimates that there will be $3.25 trillion in Treasury issuance of bond sales this year. (2)

In general, when prices of Treasuries go down, as they have been over concerns of the unprecedented government spending, mortgage rates go up. The Fed has managed to keep mortgage rates at record lows by all of the government stimulus, which is a backstop for financial institutions with toxic mortgage-backed securities. (3)

Unfortunately, as Fannie Mae and Freddie Mac’s mortgage bond rates rise (because the underlying balance sheets have troubled housing assets), there will be pressure to sell Treasury bonds due to the fear that the government’s bailout strategy will only get more expensive. To revisit the idea from above, if people sell Treasuries, the interest rate must go up on Treasuries to attract buyers. This makes the cost of raising cash more expensive for the government. Further, it increases the likelihood that the whole stimulus philosophy is unsustainable, and will implode. (2) (3)

What if we’re entering a vicious circle? As Kevin Nealon’s character from Happy Gilmore would say:

Yeah, lot of pressure. You gotta rise above it. You gotta harness in the good energy, block out the bad. Harness…energy…block…bad. Feel the flow, Happy. Feel it. It’s circular. It’s like a carousel. You pay the quarter, you get on the horse. It goes up and down and around. Circular. Circle. With the music. The flow…all good things. (4)

Treasury rates keep rising over concerns about government spending, which is designed to save the economy. Meanwhile, consumers and businesses face higher borrowing costs on homes and other already contracting lines of credit, which slow the U.S.’ consumption-based economy; the very same economy the government is trying to rescue. As the economy continues to be sluggish, an added upward pressure on Treasury rates occurs, because demand slows for the government debt, which brings down prices of these bonds and requires higher rates of return. Yikes.

___________________________________________________________________________

(1) The Wall Street Journal – Selling Continues In US Government Bond Mkt; 10-Yr Hits 3.76%

http://online.wsj.com/article/BT-CO-20090528-713639.html

(2) Bloomberg.com – Government Bond Yields Rise to Six-Month Highs; Metals Fall

http://www.bloomberg.com/apps/news?pid=20601087&sid=a7m86vHAHpjQ&refer=home

(3) ChicagoTribune.com – Mortgage rates spike on higher yields on Treasuries

http://www.chicagotribune.com/business/chi-mortgage-rates-may28,0,148534.story

(4) Hulu: Happy Gilmore – Feel the Flow