Why The Pullback Of 10-Year US Treasuries Buyers Was A Problem For The Mortgage Market In 2022

Over the course of 2022, the main buyers of 10 -Year US Treasuries all pulled back. Big investor groups in alternative investing, passive investment strategies, and wealth building, like real estate investing and private money lending, were affected.

And that’s a problem for the capital markets. And the mortgage market in particular.

See, the entities buying 10-year Treasuries — and the degree to which they’re buying them — greatly impacted how things play out in the mortgage world.

There Are 3 Primary Buyers Of 10-Year Us Treasuries:

The Fed

As part of its Quantitative Tightening policy, The Fed stopped buying bonds in Q2 2022 and started selling off some of its holdings shortly thereafter.

Foreign Governments And Foreign Central Banks

The selloff of Treasuries by foreign entities has been underway for 24 months and really picked up pace in Q4 2022.

Us Commercial Banks

The collective holdings of US Treasuries by commercial banks levelled off in Jan 2022, after a steep climb starting in June 2020. In recent months, total holdings have declined as banks have liquidated about $50B worth.

So What’s Been Happening To Bond Yields As A Result?

Bond yields went on a tear in 2022, increasing 157% YoY in the case of the 10-Year, and 523% YoY in the case of the 2-Year.

Bond yields jumped another ~50bps early in Feb in response to the uptick in CPI and the Jan jobs report.

As we’ve talked about before, strong economic data is generally bad for interest rates.

This is especially true of the jobs report; the Fed’s dual mandate requires them to maintain “maximum employment” (4%) and we’re well below that now at 3.4%.

Between that and the increase in CPI, the market is expecting more rate hike hikes ahead.

Here’s Why Bonds Going Up Is Important

Generally, the more bond yields go up, the more rates on other debt instruments go up. Like mortgage rates.

But why?

Because mortgage holders — to continue the example — want a return in excess of the 10-year Treasury yield (which is considered somewhat similar in terms of its liquidity profile, but not its risk profile).

There Was A Spike In That “Required Excess Return” Over The Last Year

We call this risk premium, which has spiked in a BIG way for Mortgage Backed Security (MBS) investors over the last year.

We’ve talked about risk premium before.

Risk premium is a measure of excess return, usually expressed as a percentage, that is required by an investor to compensate for being subjected to an increased level of risk.

It’s often thought of when comparing two investments of different risk profiles. As in, based on what I’m seeing in the broader economic world, how much riskier do I believe investment X is than investment Y? And how much extra return do I need to compensate for that additional risk?

The chart below is the risk premium that investors require for an MBS to be preferable to a 10-year Treasury bond:

It has risen rapidly over the last 18 months in concert with the Fed’s quantitative tightening, currently sitting at over 1%.

Note: an MBS is more securitized than a single mortgage, and therefore requires less risk premium than an individual note.

In short, if investors can’t get that extra 1%..they’re less likely to opt for an MBS.

This removes liquidity from the mortgage market and forces lenders to raise the interest rates they charge consumers.

Mortgage Lenders Also Hiked PremiumS

Again because there is assumed to be more risk in a single mortgage than there is a massive securitized portfolio of them.

Throughout February — after the jobs report, CPI report, and the resulting jump in bond yields — the average mortgage lender raised their rates by nearly 0.9% on a top-tier conventional 30-yr scenario.

It Had Nothing Directly To Do With Fed Funds Rate Hikes

It’s largely about:

An increase in bond yields, based on the market’s perception of future economic volatility (risk).
A higher-than-average mortgage premium, for the same reason.

If the mortgage premium over the 10-year Treasury yield returned to historical norms, 30-year fixed rates would be 5.67%, 120 basis points lower than they are today.