Interest rates have shown volatile and unprecedented movement in recent weeks. What this means for your and your clients’ wallets is complicated. To fully understand how current and potential interest rate movement will influence homebuyers, sellers and the housing market in 2020, a brief overview of interest rate basics is needed.

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Trending mortgage rates

How interest rates work

One basic principal that needs to be mentioned here: when an individual puts money into a savings account, they are essentially lending their money to the bank in exchange for an agreed-to interest rate, normally around 0.1%.

The same principle is true for when banks or individuals lend or borrow money to and from the government, a process which can take place through the purchase and sale of U.S. Treasuries.

A positive interest rate means the person parking their funds with the bank will receive a growth on their investment, the rate of growth set by the interest rate. However, when the interest rate is negative, the person is charged to park their funds, essentially paying the bank to hold onto their money for them. If you’ve never heard of negative interest rates, you’re not alone. They don’t make sense in a normal economic environment (but keep reading, because 2020 is not a normal situation for the economy).

Interest rates on short- and long-term Treasuries

Treasury (T-) Bills are short-term instruments, ranging in length from a number of days up to one year. Real estate professionals will be most familiar with T-Bills as one of several benchmark rates used to periodically adjust some adjustable rate mortgages (ARMs).

T-Bills are purchased directly from the government in an auction-style environment, or on the secondary market for a set price. The yield – return on investment – on a specific Treasury Bill equals the average auction price received at the auction.

Treasury (T-) Notes are long-term instruments, ranging from two-to-ten years in length of maturity. In the real estate world, the 10-year T-Note is most important because it is a key benchmark for longer-term mortgages, like the 15-year and 30-year fixed rate mortgage (FRM) rates.

Editor’s note — Treasury rates can also be used to forecast future recessions, as when comparing the 10-year T-Note with the 3-month T-Bill, called the yield spread. Typically, instruments with longer terms provide higher interest rates. However, in rare cases, the 3-month T-Bill will provide a higher rate of return than the 10-year T-Note. When this crossover occurs, the yield spread is negative. When the spread is negative for a period of months, it forecasts a recession to arrive 12 months later. The last time this occurred was in mid-2019, which forecasted a recession to arrive in 2020.

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Using the yield spread to forecast recessions and recoveries

When higher demand exists for Treasuries, investors are willing to accept lower yields, which translates to lower interest rates on Treasuries. In times of economic volatility, bond market investors turn to Treasuries as safe investment alternatives. Thus, when a high recession risk exists, investors purchase more Treasuries, pushing these rates down.

When Treasury yields go negative, investors pay the U.S. Government to park their money — not the other way around, as is usually the case.

Negative interest rates

In late-March 2020, the yield was negative for short-term T-Bills. For example, on March 26, the interest rate on the 3-month T-Bill was -0.05%. In other words, individuals are paying over face-value for the safety of purchasing T-Bills.

What is the strategy behind negative interest rates?

To answer this, first ask the question: why does an investor purchase an instrument with a negative interest rate?

The answer is simple: the investor believes they will be able to sell the instrument at a later date for a profit. This only happens when interest rates fall even further into negative territory.

Therefore, today’s bond market investors are hedging their bets. They believe the Fed will soon go negative, which would result in T-Bills plunging even further into negative territory.

When the Fed “goes negative” they essentially charge banks to borrow. Central banks in Europe and Japan have used this strategy in the past, though the Fed has managed to avoid it, even during the elongated recovery from the 2008 recession.

In an effort to combat the economic stagnation from the coronavirus (COVID-19), in March 2020, the Fed dropped their target Federal Funds Rate to zero. They can’t go any lower to stimulate borrowing and lending in the economy without going negative.

By going negative, the Fed pushes investors away from U.S. Treasuries into other short-term instruments. When enough investor demand exists for other short-term investments, those short-term investments likewise go negative. With negative yields on short-term investments, investors will increasingly look to long-term investments, pulling rates down on those, too.

Negative rates’ impact on the housing market

For the housing market, this domino effect of lower long-term yields translates to lower interest rates on FRM rates. Thus, end users like homebuyers, sellers and refinancers benefit from significantly lower FRM rates.

The average 30-year FRM rate hit historic lows in March 2020, averaging as low as 3.29% in mid-March. If the Fed chooses to go negative — and the bond market is betting on it — then FRM rates will fall even further.

This low rate action will boost buyer purchasing power, allowing homebuyers to qualify for higher principal amounts with the same monthly payment. Therefore, the housing market factor that stands to benefit the most from negative rates is home prices.

Real estate professionals who keep an eye on rates in the coming weeks and months will be prepared for future housing market trends. Expect the home sales volume slump to continue this spring and into summer; as long as shelter-in-place orders remain. However, the saving grace for 2020 is sustained home prices and higher rates of refinances, dependent on if and when the Fed goes negative.