How Mortgage Investment Drives Interest Rates

Often overlooked, mortgages are a key factor in the declining interest rates, according to George Pearkes, Global Macro Strategist for Bespoke Investment Group in an opinion column on Business Insider. Pearkes states that while global growth worries, Federal Reserve policy shifts, and risk aversion are all being covered as causes of the recent decline in interest rates, mortgages are another factor that has been “undiscussed and invisible to the average investor.”

Hedging, Pearkes notes, is partially behind upticks or downturns in interest rates. 

“Thanks to the unique option properties of US mortgages, large changes in interest rates cause the holders of mortgages to hedge,” he said. “That hedging activity can exacerbate declines or upticks in interest rates, creating a self-fulfilling prophecy of lower rates that runs very far before negative feedbacks kick in.”

These unique options include mass market, long-term, fixed rate, and zero or low prepayment penalty mortgages for home purchase. Investors with mortgages or mortgage back securities buy exposure to interest rates as they drop because their portfolio's exposure to rates is dropping along with interest rates, buying more sensitivity to interest rate movements from someone else. Then, as rates rise, investors hedge by selling sensitivity to interest rate movements to someone else

According to Pearkes, hedging mortgage-backed securities creates a “positive feedback loop” as billions of mortgage-backed securities are hedged by buyers desperate to buy interest rate exposure thanks to the drop in rates since last fall. When investors buy bonds to hedge their mortgage holdings, they drive rates down further. 

Long term, this will create a negative feedback loop, as less hedging is required when mortgages begun to be repaid with lower rate loans. For example, “when you repay your 5% mortgage with a 3.5% loan, the new loan requires less hedging than the old one,” said Pearkes.