Question: What Is the Relationship Between Treasury Notes and Mortgage Rates?

Answer: Treasury notes directly affect the interest rates on fixed-rate mortgages. How? When Treasury yields are higher, so are interest rates. That's because investors who want a fixed return on their money will either shop for Treasury notes, CDs, money market funds, mortgages or corporate bonds. Treasury notes are considered ultra-safe since they are guaranteed by the U.S. government. CDs and money market funds are slightly less safe, since they aren't guaranteed. However, that safety comes with a price - a lower return.

Investors who want a slightly higher return, and are willing to accept more risk, will buy mortgages. Instead of buying the mortgages directly, they usually purchase products backed by mortgages, called (you guessed it) mortgage-backed securities. When Treasury yields rise, mortgages also have to provide higher returns to attract investors. The result to the borrower? Higher interest rates.

Those who are willing to do a little research into specific companies will purchase corporate bonds, which are rated as to their level of risk. Bond yields are also somewhat affected by Treasury yields, as well.

How Do Treasury Notes Work?

Treasury notes and bonds are sold by the U.S. Treasury Department to pay for the U.S. debt. Treasury notes are issued in terms of 2, 3, 5, and 10 years, while Treasury bonds are issued in terms of 30 years. Treasury bills are issued in terms of one year or less. However, many people just refer to all of them as Treasury bonds, Treasury products or even just Treasuries. The most popular Treasury product is the 10 year note.

Treasury notes and bonds are sold at auction by the Treasury Department, which sets a fixed face value and interest rate. If there is a lot of demand for the note or bond, it will go to the highest bidder at a price above the face value. This decreases the yield, which is a common term used to describe the total amount of money you make on a U.S. Treasury note or bond. It lessens the yield because, regardless of how much you bid for the note, the government will only pay back the face value plus the stated interest rate. If, on the other hand, there is not a lot of demand, then the bidders will pay less than the face value, which increases the yield. That is why yields always move in the opposite direction of Treasury note prices.

Treasury note and bond yields change every day, because hardly anyone keeps them for the full term. Instead, they are resold on the open market. Therefore, if you hear that bond prices dropped, then you know there is not a lot of demand for Treasury notes and bonds, and that the yields increased. This makes it more expensive to buy a home, because mortgage interest rates rise. That lessens demand for homes, which puts downward pressure on home prices. This slows economic growth.

Conversely, low yields on U.S. Treasury notes mean lower rates on mortgages. This allows homeowners to afford a larger home, and renters to afford their first home. This increased demand stimulates the real estate market, which stimulates the economy. Lower mortgage rates also allow homeowners to afford a second mortgage, which allows them to purchase more consumer products. This also stimulates the economy.

Treasury Yields Only Affect Fixed-Rate Mortgages

It is important to know that Treasury yields only affect fixed-rated mortgages. The 10-year note affects 15-year conventional loans, while the 30-year bond affects 30-year conventional loans.

Adjustable rate mortgages are affected more by the fed funds rate. This is set by the Federal Reserve. It is the rate banks charge each other for overnight loans needed to maintain their reserve requirement with the Fed. The fed funds rate affects LIBOR which is the rate banks charge each other for one, three and six month loans. It also affects the prime rate, which is the rate banks charge their best customers. Since the fed funds rate affects LIBOR and other short-term loans, it also affect adjustable rates, since these typically adjust on a semi-annual or annual basis.

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