Interest rates are the result of the yield on Mortgage Backed Securities (MBS).  When MBS are sold to investors they are purchased at varying levels of demand.  If they are in low demand, the price of the security will go down and the yield (or return) will go up.  This will result in higher rates to the consumer.  When there is a high demand for these securities, the price rises and the yield falls – interest rates in turn come down.  This is simple supply and demand economics.

Why does the Yield travel opposite the Price?

This is more easily understood using an example.  If I could buy a home from you and guarantee my profit when I sell it, that would be like buying a bond.  Lets say I guarantee my profit up front to be $10,000.  If I had to purchase a home at $100,000 to make a $10,000 profit then my return (or yeild percentage) would be 10%.  But if I could buy a home for $50,000 and gain the same $10,000 profit, then my yield would be 20%.  A bond or a mortgage backed security is simply an investment with a known profit and a variable price.  So when the price goes down the fixed yield – as a percentage - goes up.

Who buys MBS?

Until last December (2008) there were two main buyers of these types of guauranteed yeild investments.  Wall Street is the main investor – mutual fund companies use these securities to offset risk of owning stocks.  The second investors are foreign countries, mostly China and a few others.   (China and other Asian countries currently own over 1/3 rd of our debt.)  Last December, on their own, interest rates were around 6% to the consumer on a 30 year fixed rate loan with no points based on the activity of these two main buyers.

Enter the US Federal Reserve.

In an attempt to bring long term interest rates to a target of 4.5% and moving as fast at the Treasury’s printing presses could carry them, the US government became a competing buyer for this kind of debt creating a “false demand” for MBS which drove the prices up.  This in turn caused the yields to decline and at their lowest, the consumer was able to lock in at 4.875% with no points a time or two during the past year.

When will they Stop?

The Fed decided originally to spend around $750 billion buying treasuries, bonds and securities and then earlier this year bumped that to $1.25 Trillion.  As of last Friday $977 billion have been spent leaving $277 billion in purchases over the 22 weeks that remain in the program.  The average purchases have been around $20-25 billion per week all year.  This will decline to about $12 billion per week through the end of the year and then drop off.

Prices will almost assuredly fall.

If that happens, the rates WILL rise.