Low mortgage rates defy expectations

By Nell Henderson

updated 5:21 p.m. ET June 2, 2005

Mortgage rates were supposed to be rising by now, helping to gradually cool the nation's red-hot housing market.

The Federal Reserve has been raising short-term interest rates steadily for nearly a year. The economy is growing at a healthy pace. Energy costs are up. If history were a guide, long-term rates would be rising, too.

But they are not. Even Fed Chairman Alan Greenspan has called this a "conundrum."

Defying predictions, U.S. mortgage rates are lower than they were a year ago and are falling. That's a large part of why home sales and prices are at record highs and are fanning worries of a real estate investment bubble.

The rate on the average 30-year fixed-rate mortgage fell to 5.65 percent in the week that ended May 26, the lowest rate since mid-February and below the 6.32 percent level of a year ago, according to mortgage financier Freddie Mac.

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"The housing market is going to be robust if rates stay where the are," said Freddie Mac's chief economist, Frank Nothaft. "But it's hard for me to fathom why they would stay this low for long."

While home buyers cheer the bargain borrowing costs, some economists admit to being puzzled and concerned. If mortgage rates keep sliding, they will pump up any bubble. But if rates snap up suddenly, a bubble could pop, with both prices and investment dropping sharply, hurting many borrowers and investors.

Global financial markets, not any government body, determine long-term interest rates through their bond trading each day. High demand for bonds pushes up their price and drives down their yield, yield being their effective interest rate after factoring in their purchase price. A combination of factors keep driving demand and pushing rates down, forces that have "much more to do with speculation, hedging and politics than . . . with actual investment merit," wrote Peter Schiff, president of Euro Pacific Capital Inc., a Newport Beach, Calif., investment firm, in a recent analysis. "Once these forces reverse, expect bond prices to plunge and interest rates to soar."

Mortgage rates are largely determined by the yield on the 10-year Treasury note. Last June, when the Fed's benchmark short-term rate was 1 percent, the 10-year yield was 4.69 percent and the average 30-year mortgage rate was 6.25 percent.

Since then, Fed officials have raised their benchmark federal funds rate, which is charged on overnight loans between banks, to 3 percent and indicated they plan to move it higher to keep inflation in check. But the 10-year yield has fallen below 4 percent, to 3.88 percent yesterday -- the lowest level since March of last year.

Some analysts are now predicting it will keep sliding. Merrill Lynch's interest-rate committee last week lowered its yield forecasts, projecting the 10-year Treasury to yield 3.8 percent by year's end.

Morgan Stanley's chief economist, Stephen S. Roach, on Tuesday predicted that the yield could reach 3.5 percent in the next year. That represented a turnabout for someone who had insisted for months that interest rates would eventually rise as part of a correction of the nation's huge trade deficit.

Economists are now studying the "conundrum" intensely, finding a variety of partial explanations.

Some point to short-term issues. For example, one factor that helped push down yields yesterday was a Fed official who implied in an interview that the central bank would stop raising its benchmark rate after its meeting later this month. Richard W. Fisher, president of the Federal Reserve Bank of Dallas, said during an appearance on cable network CNBC: "We're clearly in the eighth inning of a tightening cycle. . . . We have the ninth inning coming up the end of June," according to a partial transcript by Bloomberg News.

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