Securing a cheap mortgage
With the recent decline in government bond yields in the US and Europe, homeowners have been inundated by advertisements enticing them to take advantage of cheap mortgage rates. Despite the Fed’s interest rate hikes, 30-year mortgage rates in the US are hovering around 4% these days, the lowest level since 2017. Let’s ignore for a moment that because we have been in a multi-decade downward trend in interest rates, homeowners would always have been better off choosing a short-term or adjustable rate mortgage rather than a long-term fixed rate mortgage. After all, interest rates won’t go lower forever. However, I have made an argument here that interest rates – and with it mortgage rates – cannot go much higher either because there are so many homeowners with floating rate mortgages that a normalisation of interest rates could potentially create another housing market crash. And once house prices drop precipitously, central banks would almost immediately be forced to cut interest rates again. Thus, one can argue that interest rates must stay low for a very long time in the future.
But if a homeowner wants to reduce the uncertainty of future mortgage payments, one can lock in low mortgage rates now, if you already own a home. However, what are Millennials and other investors supposed to do who do not have a home yet but want to lock in these low mortgage rates? Rising interest rates are likely to put a drag on the performance both of bonds as well as stocks, especially if the increase in interest rates continues for an extended period. Thus, investing in stocks and bonds may not be the optimal solution in times of rising long-term rates.
One possible solution is to hold savings in Treasury Bills and other floating rate bonds. Unfortunately, central banks seem to be poised to keep short-term interest rates low for a long time even if inflation and long-term rates rise. Thus, such an investment is unlikely to benefit much from rising long-term interest rates. A better option may be ETFs that are designed to benefit from rising long-term rates. Take for instance the ProShares Short 20+ Treasury ETF (Ticker: TBF), an ETF that tracks the inverse performance of the ICE 20+ years Treasury Index. If interest rates rise, TBF increases in value. A historical analysis of the performance of TBF shows that this ETF does a good job in tracking the inverse performance of long-term Treasury Bonds in the US. The correlation between the performance of TBF and the inverse of the benchmark index is 99.5%. Thus, investors who want to benefit from rising long-term government bond yields in the US are well served by this ETF.
But if you want to hedge the risks of rising mortgage costs of your future home, TBF seems an imperfect solution at best. The problem with mortgage rates is that they are offered to homeowners by banks who – incredibly – want to make a profit. And because these banks want to make a profit, they tend to engage in two tactics that make life hard for homeowners. First, if interest rates decline, banks tend to lower mortgage rates only with some delay. This is done because if interest rates dip only briefly, they can leave long-term fixed mortgage rates unchanged and cash in on a higher margin for a few weeks or months.
Second, if long-term interest rates drop to very low levels it is impossible for banks to mirror this decline in long-term government bond yields one to one because that would erode their profit margins and cause all kinds of problems with the share price and the bonus of top executives. This effect is visible in our chart below where the gap between the performance of TBF and the development of 30-year mortgage rates in the US increases as rates drop. This can be seen most clearly in the extreme case of Switzerland, where 10-year fixed rate mortgages are the longest maturities available in the mortgage market. 10-year Swiss government bond yields have been negative since 2015 and have gone as low as -0.64% in 2016. Yet, 10-year mortgage rates have continued to hover above 1.4% and the spread between mortgage rates and government bond yields increases rapidly, once government bond yields decline to levels below 0.5%.
In summary, if you want to invest to benefit from rising government bond yields, inverse Treasury ETF may be a solution in those countries where they are available. But there is no reliable way to lock in current low mortgage rates if you do not already own a home. So, if you are worried about rising rates, go ahead and buy a fixed rate mortgage but keep in mind that you might be wrong and if interest rates remain low for long, then the better choice would likely be to hold a floating rate mortgage.
Performance of TBF and 30-year mortgage rates in the US
Source: Bloomberg, Fidante Capital.