Treasuries Defy Fed's Mortgage Strategy

Even the Federal Reserve has limits when it comes to influencing benchmark interest rates. Despite federal efforts to keep residential and commercial mortgage rates down, long-term Treasury rates threaten to choke borrowers with a higher cost of capital.

The 10-year Treasury rate, a benchmark for commercial real estate lending, climbed to 3.76% in June from 2.42% in December. Some forecasters say interest rates will climb another 100 basis points or more by the end of this year due to the amount of government debt being issued to finance record budget deficits.

The 10-year Treasury rate, a benchmark for commercial real estate lending, climbed to 3.76% in June from 2.42% in December. Some forecasters say interest rates will climb another 100 basis points or more by the end of this year due to the amount of government debt being issued to finance record budget deficits.

“This is a simple supply and demand issue,” says Sam Chandan, president of Real Estate Econometrics. “If the Treasury increases debt issuance fourfold, for the market to clear, the price of Treasuries has to fall.”

Observers worry that escalating borrowing costs will hinder Washington's attempts to stimulate the economy. The rise in interest rates was enough to prompt the Mortgage Bankers Association to slash its projections for residential and commercial real estate lending volume this year by $700 billion.

In June, the MBA projected mortgage originations this year will total $2.03 trillion, down from a March forecast calling for $3 trillion.

Some forecasters are more sanguine. The 10-year Treasury rate retreated slightly to 3.5% in late June. Bob Bach, chief economist at Grubb & Ellis, expects the rate to remain near that level through the end of the year.

“If interest rates rise, that's going to jeopardize the recovery,” Bach says. “So the Federal Reserve is going to do what it has to do to keep interest rates down.”

The Fed has one hand tied behind its back, however. The overnight Fed funds rate — the only interest rate it can lower directly — is already below 0.25%. The only means available now to reduce long-term interest rates is quantitative easing, or manipulating the supply and demand factors that investors use to determine pricing.

If the Fed can buy up enough Treasury bonds, then investor demand for the bonds still available for purchase will keep yields in check. That strategy has failed to contain Treasury rates, although the Fed has kept down mortgage rate spreads through a similar program of buying mortgage-backed securities (MBS). The Fed has purchased 85% of MBS issued by Fannie Mae, Freddie Mac and Ginnie Mae since the end of the first quarter, according to the MBA.

Those securities are backed by both single-family and multifamily residential loans. The Fed only purchased about half of Treasury debt issued in that same period, however, and may be nearing its self-imposed ceiling of $300 billion for Treasury purchases.

In March, the MBA warned that inflation expectations and a shrinking dollar could make investors shy away from Treasuries, curtailing last year's drop in interest rates and reducing the outlook for mortgage lending. Now, as MBA Chief Economist Jay Brinkman observes in the MBA's revised mortgage forecast, “that has proven to be the case.”