"The Trend Is Your Friend Until The End When It Bends"-Marty Zweig On Friday, January 12th the two-year United States Treasury Note closed trading at 5 PM New York time with a yield of 2.002%. This security has not traded with a “two handle” since September of 2008. If short-term bonds become more attractive, so will long-term bonds likely drop in price thus raising their yields. Mortgage rates would then rise and that would affect housing prices, real estate development, the construction industry, and send recessionary ripples through the rest of the economy. Bill H. Gross tweeted that the recent rise in treasury yields confirms a bear market in US Treasury securities.
It is said that the three most important concerns in the real estate business are location, location and location. The same might be said about the finance industry, except that the three would be timing, timing and timing. Bill H. Gross, possibly because of the timing of his birth in the first year of the baby boom after World War II, simultaneously entered the prime of his working years and the highest historical interest rate environment.
Mr. Gross established Pacific Investment Management (PIMCO) in 1985 when AAA rated U. S. Treasury Bonds carried higher than 15% interest rates. To his credit, he was able to recognize an opportunity in the highest quality debt on the planet with yields that had never been seen before and may never be seen again. He bought and kept on buying. To his further credit, and the reason he became known as “the bond king,” he continued to “go long” treasuries through the occasional upswings in yields and downswings in bond prices over his three decades in business. While others in his profession were whipsawed by fears of the return of the rampant inflation of the 1970’s, the enduringly prescient Mr. Gross continued to buy US Treasuries over the succeeding decades as yields dropped from double to single digits, and then approached zero during The Great Recession.
In 2008, The Federal National Mortgage Association (FNMA) and The Federal Home Loan Mortgage Corporation (FHLMC) were bailed out by the US Treasury Department. Bill Gross and PIMCO had been actively accumulating FNMA and FHLMC mortgage bonds while at the same time selling short the preferred stocks of those same companies. The US Treasury Department purchased FNMA and FHLMC mortgage bonds for its own portfolio but abandoned the preferred stocks of those same government agencies. Bondholders were made whole while stockholders were left with worthless paper reminders. With that bailout, Bill H. Gross and PIMCO netted a $1.7 billion profit. But now the man who was right and right again about the enduring bond bull market has said that the trend has come to an end.
The yield on the ten-year U. S. Treasury Bond, the rate most highly correlated with home mortgage rates, has now risen to 2.59% from a low of 2.06% on Friday, September 8th as Hurricane Harvey approached Texas. Any change in an interest rate that starts with a “2” may seem insignificant, but a move of one-half percentage point, at this level, is a 25% increase in the income a buyer would receive today versus four months ago. On a $1 million investment that is an increase of $5000 annually. But if an investor can now receive 2% from a 2-year bond rather than locking up funds in a much longer investment, as has been the case over most of the last decade, then more bond buyers may buy the two-year treasuries rather than the tens.
Ten-year treasuries are closely correlated with the rates of conventional fixed-rate 30-year home mortgages. In June of 2017, when the ten-year US Treasury Note was priced at a 2.16% yield, the average 30-year mortgage rate was 3.69%. Now, with the ten-year treasury yielding 2.59%, the average 30-year mortgage rate is 4.18%. Mortgage rates rise at least as fast in yield as the ten-year Treasury note. As mortgage rates rise, fewer potential homebuyers qualify under the “30% rule” of The United States National Housing Act of 1937. As of January 2017, the average home mortgage in the United State was $309,200. The monthly payment on a mortgage that size at 4.18% would be $1503 per month or $18,036 per year. A mortgage applicant would have to earn at least $60,120 per year in order to qualify. According to the United States Census Bureau, the median income in the United States was $59,039 in 2016.
If the ten-year treasury moves down in price and up in yield to near its historic average of 4%, where it was at the beginning of 2008, then a 30-year mortgage would likely carry an interest rate of at least 5.5%. A homebuyer applying for a loan of $309,200 would then be required to have an annual income of $69,880. With a sustained rise in the yield of ten-year treasuries, and a consequent rise the 30-year mortgage rate, more homebuyers would be priced out of the market.
Fewer qualified homebuyers would mean lower demand for housing and a fall in the real estate market. Bankers, hopefully, would not again lend to unqualified buyers (as the did in the early 2000’s), real estate developers would scale back future projects, construction firms would layoff workers, and orders for building materials would be canceled. The economy would contract, but that is not necessarily a bad thing. The higher the altitude, the nastier the fall.
In the fall of 2008 began the search for a solution to a seemingly impossible puzzle for then-Treasury Secretary Hank Paulson and incoming President Barack Obama. On a monetary scale, it was an effort equivalent to fighting a world war. What began as an effort to prop up an over-leveraged and free-falling economy became one of the shrewdest financial strategies in history. Beginning in 2008, the U. S Treasury was able to borrow trillions of dollars at near zero percent interest rates in order to subsume distressed mortgage-backed bonds, asset-backed securities, and even corporate bonds and stocks from companies like General Motors and American International Group.
The United States has effectively refinanced its debt at the lowest rates in its history while acquiring a portfolio of high-yield fixed income securities at bargain-basement prices. The $20 trillion United States national debt is now 103% of its gross domestic product, but the interest rate it is paying on that debt is also lower than any time since World War II. Unemployment has fallen from 10% ten years ago to a level below what had conventionally been considered “full employment.” So far so good, but the United States could become a victim of its own economic success. The Millennium Generation may be introduced to the inflationary evils only their grandparents remember, and Bill Gross may go “two for two” in his career of calling the long-term trend.