The correlation between mortgage prices and Treasury bond prices is ultimately decided by where investors want to spend their cash. The structure of the mortgage system in the USA places mortgage rates in competition with the prices paid on U.S. Treasury bonds. The interest rate trends on Treasury bonds may be used to roughly predict the rate trends for fixed-rate mortgages.
Most home mortgages, especially those covered by the Federal Housing Administration (FHA), are packed into mortgage pools and offered to investors as mortgage-backed securities. The mortgages are “securitized.” The principal issuers of those securities are Ginnie Mae, Fannie Mae and Freddie Mac. The securitization of home mortgages means that mortgage lenders do not keep mortgage loans in their books as assets.
The mortgage securities offered by Ginnie Mae, Freddie Mac and Fannie Mae have indicated government backing. This top quality level gives mortgage securities of those agencies AAA credit ratings and sets them in direct competition with Treasury bonds for investor cash. So if Treasury rates increase, the rates on mortgages will increase to keep the prices paid by mortgage-backed securities aggressive with Treasury bonds. Declining Treasury rates have exactly the same impact on mortgage prices.
According to the Investopedia site, a 30-year mortgage has an average lifetime of 7 years. Personal mortgages and mortgage pools receive both principal and interest payments as homeowners make their payments, refinance their mortgages and market their houses. The result of this anticipated life of mortgage securities is the fact that 30-year mortgage prices are correlated with the rate of their 10-year Treasury bond.
The interest rate spread between the 10-year Treasury and adapting FHA mortgages has been 1.7 to 2%, with mortgage rates higher. In early 2009 the spread jumped to over 3 percent as Treasury prices began to decline and mortgage rates did not follow. In mid-2010, the spread tightened to about 1.5 percent when the comparatively few new mortgages weren’t enough to present mortgage-backed securities for willing investors, and 3.6 percent from a Ginnie Mae mortgage-backed safety looked a whole lot better than 3 percent from a 10-year Treasury.
The entire spread between Treasury bonds and mortgages doesn’t end up with mortgage-backed securities investors. Mortgage payments are collected by mortgage service companies, which keep a portion of the interest to cover their services. The interest in Treasury bonds is exempt from state income taxes and mortgage-backed safety interest isn’t, giving a small benefit to Treasuries. The elastic nature of principal payment out of pass-through mortgage securities also makes them a little more difficult than Treasury bonds with a fixed maturity. Every one these factors accounts for the higher return on mortgage-backed securities and the rate spread between Treasury bonds and mortgages.