BigPimp

What will mortgage interest rates be for next year?
Mike, Address withheld

This is the time of year the financial press is loaded with predictions about where the economic and financial markets are headed for the coming year. You can choose from a wide array of pronouncements from some of the best minds in the business, confidently served up to help you plot your personal financial course for the next 12 months. So here’s an answer you probably won’t see among all those sage forecasts on where interest rates are headed.

Our answer is: no one knows. If they say they do, they're lying. You might as well ask what the temperature will be in Central Park on Aug. 23 at 5:36 p.m. But if you want to play along at home, while watching interest rate “experts” expound on the subject, here are a few things to consider:

In order to predict where long-term mortgage interest rates are headed (or even the short-term lending rates set by Federal Reserve decree), you need to make several other, fairly dicey predictions first. For starters: will global demand remain strong for mortgage debt – and all the other paper like U.S. Treasuries, corporate and municipal bonds, etc. -- churned out by anyone and everyone who wants to borrow money? (When you get a mortgage, your loan is often quickly sold off to these investors to free up more cash to lend to the next borrower.)

So far, the world’s savers (who ultimately generate all this cash) have been happy to buy up this paper at historically low rates of return. But these buyers – everyone from pension funds to foreign governments to individual investors – could begin to lose their appetite. Maybe they’ve bought all the paper they need for awhile. Or maybe they start to wonder, how they heck are debt-gorged consumers – not to mention Uncle Sam -- ever going to pay all this money back? If that happens, these bond buyers could begin to demand a bigger payoff before parting with their hard-earned cash. That higher payoff means higher interest rates on all this debt.

Then, while you’ve got your crystal ball powered up, ask it where inflation is headed -– a question that is currently subject to a number of differing “expert” opinions. Some economic gurus suggest that the recent surge in energy prices will inevitably spill over into higher inflation, much as the oil shocks of the 1970s sent prices of everything soaring. Others argue that (for a variety of reasons, including the fact that the U.S. economy uses about half as much energy per unit of GDP as it did 30 years ago), inflation won’t be a problem. (Your guess is as good as the best-paid economic analyst.)

To make your mortgage rate prediction, you need to know the inflation rate for 2006 because interest rates and inflation tend to move in the same direction. The reason is pretty simple. If inflation rises, that means a dollar of savings at the start of 2006 has less buying power by the end of the year. So if those bond buyers (again, the folks who ultimately supply the money for your mortgage) see inflation rising, they’re going to want more interest to make up for the loss in buying power of their dollars. In the 1970s, the worst part of the inflationary cycle pushed mortgage rates above 18 percent.

It would also help armchair rate forecasters to know which way the dollar was headed over the next 12 months compared to other currencies. A lot of the cash that is soaked up by the bond market comes from overseas -– so a drop in the dollar eats away at savings that start out in another currency. To make up for the money they’ll lose from a drop in the dollar’s buying power when they bring their savings back home, those savers will demand higher interest rates, too.

Lister00169

Very good read! I love it when people overreact to the Fed raising the overnight lending rate.