Debt Downgrade and Mortgage Rates – Now What?

The United States Debt Downgrade: Why Did it Happen and What’s Next for Mortgage Rates?

It is not often that one can look at an event occurring in the news and say “We’ve just experienced history”.  Recently, that is exactly what happened.  The U.S. debt was downgraded by one of the bond rating agencies, S&P (Standard & Poor’s) and the way that the world views the United States as the world’s bastion of safe investments will never be the same . . . or will it?

In order to predict any potential impact, it is important to understand who the rating agencies are, what happened and why. 

The rating agencies found a niche by providing “objective” “market intelligence” to assist investors in determining risk when selecting investments.  They rate everything from stocks to bonds to mutual funds and more.  This market intelligence is supposed to give investors a gauge of the value or risk of one investment in comparison to others.  After all, the only way an investor can outperform the market is to buy investments that outperform others – regardless of how the overall market is doing, this relative performance is what measures success in the markets.  If the market is up, the investor with the highest gains is outperforming.  If the market is down, the investor with the lowest losses is outperforming.

Recently, S&P downgraded the long term U.S. debt from its highest rating of AAA to AA+.  They also adjusted their long term stance to “Outlook Negative”.  S&P cites the reasons for this downgrade: “Political Risks and Rising Debt Burden”.  Hardly a surprise to most people who have been observing the government increase in debt and the political wrangling over how to deal with it, yet the downgrade itself did send shockwaves through the media (notice that I said media and not markets).  Many investors have been anticipating this downgrade and actually priced their investment expectations on the assumption that S&P would announce the downgrade.

It is also important to note that only one rating agency has announced the downgrade (as of the writing of this article) and that puts them alone in this downgrade.  Some other popular rating agencies that you may have heard of that have NOT downgraded the U.S. debt: Fitch Ratings, A.M. Best or Moody’s.  The fact that none of the other agencies have followed suit and downgraded their ratings yet will likely have an impact on the market perception of S&P’s announcement.

So What Happens to Mortgage Rates?

If you were looking for a prediction here, I’m sorry but you will be disappointed.  What I will do is to lay out 3 potential scenarios and we’ll have to see which plays out over the short and long term.

Potential Scenario 1:  Panic in the Bond Markets

Due to the downgrade, one would expect investors to pull out of the U.S. bond market in droves.  As mortgage backed securities (the investment used as the basis for determining mortgage rates) tie closely to the performance of U.S. issued 10 year Treasuries one would expect to see a significant increase in rates should this happen.  As we are already a few days out from the downgrade and panic has not set in, this scenario of an enormous short term spike in mortgage rates is not likely.  However, stay tuned.  With rates at historic lows and perceived risk increasing due to the downgrade, things could change very quickly.  Anticipating a shot term spike in rates of .25% would not be unreasonable.

Potential Scenario 2:  Mortgage Rates Could go Down

If there is one thing investors don’t like, it is uncertainty.  The current economic conditions, political theater and the recent debt downgrade all point to the exact type of uncertainty that roil the markets.  When investors are uncertain about the potential risks of investments they typically engage in what is known as a ‘flight to safety’.  Simply put, they pull their money out of risky investments and move them into investments that are perceived as safer (historically this has been U.S. Treasuries).  As you can see, this is where the rating agency downgrade confuses things a bit.  By downgrading U.S. debt, the S&P has raised a question about the relative safety of U.S. debt and creates uncertainty about where investors can park their money for safety.  Remember, however, that only one agency has issued the downgrade and in relation to the rest of the world’s investments, U.S. Treasuries still look very safe.  A flight to safety, in the short term, appears to be the direction.  As people move into Treasuries, Mortgage Backed Securities should follow that pattern.  At some point, we will see that change.  When it does, it will likely be unexpected, abrupt and painful as money pours out of the low returns of government debt and back into the stock markets where much higher returns are the goal.  This will mean a significant spike in mortgage rates.

Potential Scenario 3:  Not Much Changes . . . For Now

I believe this is the most likely short term scenario.  I believe that the uncertainty of the economy right now outweighs the single downgrade by S&P.  However, if we start to see other agencies jump on the downgrade bandwagon it could spell trouble for our bond markets.  Again, we will see mortgage rates rise.  The question will be how fast and how much.

If you are considering buying, refinancing or selling your home – NOW is the time to investigate these options in earnest.  Many borrowers sat on the sidelines when rates dropped to the 4% range over the past year.  I heard a lot of people say that they expected rates to go down.  Many of those people bought or refinanced when rates spiked to 5% because their predictions were wrong.  Don’t let this happen to you.  We are in an incredibly low rate environment and, while it may still not make sense for everyone to buy or refinance, the time is now to investigate the option.

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