President Trump presented his 2020 budget to Congress in March. The budget is more a symbolic declaration of priorities for the administration as it is Congress, not the White House, that dictates actual spending. Still, other projections suggest deficits that are large and persistent. I thought it worthwhile to write a short note on deficits in general and their likely influence on mortgage rates in coming years.
When the U.S. government runs a deficit, it is spending more on government programs than it receives in tax revenue. In order to make up for the short fall, it must borrow. To do so, it issues various IOUs with different maturities – Treasury bills require payment in as little as 4 weeks while Treasury bonds may not be due for as long as 30 years. Because these securities are thought to be risk-free and trade easily and frequently (i.e. they are highly liquid) they form the anchor or reference for interest rates throughout the economy, including mortgages. We have included a chart below illustrating that anchoring effect – where the 10-year treasury goes the mortgage rate often follows.
It is clear then, to at least a rough approximation, that if we can think through the effects of continued government deficits on the interest rate of the 10-year Treasury note then we’ve answered the more relevant (at least to us!) question of what will happen to mortgage rates. The conventional answer to this question would go as follows: all else equal, if you increase the supply of something, its price will fall.
When the U.S. Government runs deficits, they need to issue more (read: increase the supply of) Treasuries. When the price of a bond falls, its yield (a fancy name for interest rate) goes up. Thus, continued deficits should raise the 10-year rate and, by extension, mortgage rates. Let’s look at the data.Source: U.S. Treasury, Bloomberg
Does it always work that way? No, it doesn’t. Why not? Well, in the real world nothing is ever equal. We can see in the 2008 crisis, for example, that the government ran a huge deficit yet interest rates fell. Even in the face of a huge increase in the supply of Treasuries, the price went up as demand for the safety afforded by the U.S. government outweighed the increase in supply. Even foreign investors flocked to U.S. Treasuries.
One way to look at the problem is to recognize that the U.S. Treasury will be competing with borrowers in mortgage and other credit markets for the supply of savings available over the next few years.
In 2008 other borrowers disappeared, making lots of room for the U.S. Treasury. Today, with private credit demand strong, a larger than expected federal deficit would mean that the Treasury would have to pay more to “crowd out” other borrowers.
If enacted, the proposed Trump deficit will be large and persistent and will tend to put pressure on mortgage rates. In fact, the situation might be especially suited to higher rates. With the economy running near full capacity (as proxied by the very low unemployment rate) whatever the government spends its deficit dollars on may, rather that increase the number of goods produced, do more to raise the prices of those goods. This is inflation. When inflation increases, bondholders demand higher interest rates to compensate them for the loss of purchasing power their dollars will experience over 10 years.
So far, expectations about inflation and interest rates have not been jolted by the prospect for very large fiscal deficits. Moreover, the proposed budget is not a big surprise and may already be baked into market interest rates. But history teaches us that expectations can change rapidly. Large deficits could push Treasury rates higher and we may not get much warning. In our view, the Trump deficit increases the risk of rising long-term interest rates. This would surely extend to mortgage rates and suggests that locking in financing now is an attractive strategy.