If you are like me you would rather not think about the fact that China, while attempting to address their economic problems, might have a significant impact on the mortgage interest rates we pay. But even though I’d rather not think about it, I’m paid to do so, so here I go.
How are mortgage rates “set?”
Let’s review how mortgage rates are determined. Lenders get their money from institutional investors (insurance companies, pension funds, countries, etc.) who need to earn a certain yield on their cash reserve investments to make money. There are middlemen, like Fannie Mae, Freddie Mac and Wall Street investment bankers, but ultimately the folks who determine what your interest rate is going to be are the ones who decide how much cash they will invest at given yields.
China lends money to the U.S. government and to U.S. homeowners
China parks some of its money in U.S. Treasury Bonds and mortgage-backed securities, so to some degree when China invests in these instruments they impact mortgage rates. How much does China hold? According to Marketwatch, as of December 2015 China held $1.246 trillion of Treasuries. The figures on mortgage-backed securities are harder to come by, and undoubtedly are much lower.
Why is this important? What this means is that China has lent the U.S. Government $1.246 trillion, and presumably hundreds of billions to American homeowners. The more lenders there are for a set number of borrowers the lower interest rates go, if economic theory holds. So what’s the problem?
China has a cash-flow problem
Because of a slowing economy, China has a cash-flow problem. And what do you do when you have a cash-flow problem? Cash in some of your investments. According to Marketwatch, China is selling at least $18 billion worth of U.S. Treasuries a month right now, and possibly as much as $40 billion. (Much of their holdings are held by intermediaries and not possible to identify with 100% accuracy.)
When lenders pull out of the market interest rates go up, so this could be important. If they begin to sell mortgage-backed securities at anywhere near this level, we could see demand lessen significantly, which would bump interest rates up.
On the other hand, the Federal Reserve is still buying most of the mortgage-backed securities that come on the market every month, so even if more came on the market the impact would be somewhat mitigated.
But according to the Butterfly Theory when a butterfly in the Amazon flaps its wings a storm brews on the other side of the world. So…how else might China’s selling spree impact us?
The U.S.’s debt to China is China’s problem
When there are more sellers the price (value) of anything drops, right? When investors dump stocks, for instance, stock prices go down. We all know this. When investors dump bonds, they go down in value too. So what do you do when you hold over $1.2 trillion worth of bonds? If you sell them too quickly, the value of your own investments drops like a rock, long before you can sell them all.
There is an old saying: “If you borrow $1 million from the bank they’ve got you by the ears. But if you borrow $1 billion from the bank you have them by the ears.” (Cleaned up for family viewing…)
China cannot really “dump” their holdings in U.S. treasury bonds and mortgage-backed securities without destroying their own treasury. If it is true that they are selling $40 billion of bonds per month, then they are dumping about 3% of their holdings each month, so it would take them almost 3 years to dump all of it. They can’t sell at that pace and cash in a significant portion of their holdings quickly enough to sell it all before impacting whatever they continue to hold, so they will no doubt roll that back in short order in order to avoid destroying their own interests.
A million moving parts
The interest rate market is a huge, complicated machine with a million moving parts. China’s dumping of U.S. Treasuries is not the whole story by a long ways, but it can potentially be a major factor. It will be worth watching over the next couple of months.
Information in this article was based on This Article in Marketwatch.