What is the current 10 year yield?
- The 10 year yield on a 10 year U.S. government bond currently stands at 2.88% as of the January 16th close, just 4 basis points above the prior low of 2.83%. This is just 30 basis points above the rate of inflation as measured by the consumer price index.
- With inflation currently running at 2.50% and the yield on the 10 year near all time lows. 10-year yields are not a useful indicator of market sentiment for the real economy or the prospects for investment going forward. The 10 year yield is also now just 10 basis points above the lowest yield on a 10-year bond of 3.97% reached in 2007.
Where will the 10 year yield go in the future?
- These 10 year lows are occurring at a time. When the number of potential home buyers in the United States is 10% below the historical trend. This discrepancy between potential home buyers and the total pool of potential home buyers has been a trend dating back at least to 2001. While housing starts have risen in recent months, this increase is being driven by speculation rather than actual demand.
- This supply and demand discrepancy, combined with a yield near all time lows, suggest that the 10 year yield could begin to rise as potential home buyers lose their fear of missing out on owning a home, which is pushing demand for mortgages. This increasing demand would increase the required mortgage rates for the average home buyer. This additional cost to borrowers could result in mortgage defaults which would put downward pressure on mortgage rates. This scenario would likely occur during the next economic downturn. At that point, the level of mortgage defaults could reach the average level during the 2001 recession, and the 10 year yield could rise above 3%.
Is the yield on the 10 year likely to rise above 3% in the next 10 years?
- On the contrary, we estimate that the 10 year yield will decline to the 1.50% area during the next decade. This estimate is based on a realistic assumption that mortgage rates will decline from the current 2.60% to just 2.50% by the end of the decade. A potential drop to this level of mortgage rates would force a sizable increase in the number of mortgage defaults which would put upward pressure on mortgage rates. This scenario would make the 10 year yield more useful as a recession indicator, but it would not provide a clear indication of where the 10 year yield is likely to go in the next 10 years.
- Even with mortgage rates rising to the 3.0% level, this level of mortgage rates would still only be 15 basis points above the long-term inflation rate.
How is this analysis different from the current yield on the 10 year bond?
We estimate that the 10 year yield is likely to drop to 1.5% over the next decade. This decline in the yield could occur through a combination of an increase in mortgage rates, which would create a significant increase in mortgage default rates and a decrease in the amount of money flowing into housing. These two developments combined with the increased downward pressure on mortgage rates would cause mortgage rates to increase dramatically in the next decade. The increase in mortgage rates could be offset by the increased demand from potential home buyers. Which would offset a significant portion of the decline in mortgage rates.
Of course, the rate of inflation is much lower today than it was in 2007. But the 10 year yield is also significantly lower than it was in 2007. This means that the ratio of the 10 year yield to the 10 year inflation rate should be at its all time low. This adjustment is important for the adjustment to be at an average level and not the lowest rate on record. We are likely to be talking about the 10 year yield approaching the 3% level. Much sooner than the yield on a 10 year bond is currently near its all time low of 3.97%.
There are plenty of reasons to believe that we will reach this level before the end of the decade. Housing starts and mortgage rates are both increasing significantly. It appears that home prices are beginning to stall in some areas.
If we add these indicators together. We should expect mortgage rates to decline to an average level by the end of the decade. This means mortgage rates will likely be slightly above the 3.0% level by the end of the decade. This would make it very easy to believe that we will have mortgage rates above 3%.
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Historical observations
Even if mortgage rates stay below the 3.0% level for a few years. There would still be a substantial amount of mortgage defaults before we reached the 3% level.
If the 10 year yield rises from the current 2.60% to the 3.0% level in the next decade. Mortgage rates would rise by 1.5% in 10 years, even if home prices only grow by 3%. This would make it very easy to believe mortgage rates will be close to 5.0% in 10 years.
