Crisis in Europe Causes Short Term Mortgage Rate Decline

Markets continue to be jittery today as traders are concerned that a $1 trillion bailout package will not be enough to prevent defaults by debt-encumbered European nations.  The ramifications of default would be widespread, as the intertwined nature of European banking means that apparently stable German and French banks hold hundreds of billions of dollars in debt from troubled countries such as Portugal, Greece, and Spain.

It is important to bear in mind that the bailout package was intended to protect French and German banks from default risk as much as help debt-ridden countries.  There are fears that soveriegn defaults could result in a dissolution of the Euro currency, which is already close to a four year low against the dollar.

The debt contagion in Europe was the catalyst for a series of events that have resulted in mortgage rates dropping to the lowest levels in 2010.  The average rate on a 30-year fixed rate mortgage fell to 4.93 percent at the end of last week.

Just a few months ago, it was considered fait accompli that the Federal Reserve would raise interest rates sometime before the end of the year.  Just a month ago, futures markets showed a 73 percent possibility that the Fed would raise rates by the end of 2010.  That number has fallen to 40 percent because of the crisis in Europe.

Banks are reluctant to engage in overnight lending.  American Money markets have reduced lending to European banks and are demanding higher returns in exchange for increased risk.  As a result of this, the Federal Reserve opened currency swap lines with Europe last week. The currency swap lines provide the European Central Bank and other major European banks with liquidity and access to funding.  Analysts believe the Fed’s willingness to open swap lines shows they are focused on global recovery and not raising rates.

Chicago Fed president Charles Evans has been in favor of low interest rates, with the warning they will increase over time.  Now he says “The risks, obviously, with the global situation make things a little bit more uncertain than we were expecting.  If anything, I’m even more comfortable with my assessment that [interest rate] accommodation continues to be appropriate”.

Although rates have been driven to 2010 lows and the Federal Reserve appears unlikely to tighten monetary policy any time soon, events in Europe could indirectly cause mortgage rates to go up eventually.  As the supply of overnight loans for European banks has dried up, the overnight rate has increased.  One measure of the overnight rate, the London Interbank Offered Rate (LIBOR) is increasing steadily.  This could have direct implications on rates in the United States because LIBOR is the basis for many mortgage rates and credit card interest rates.

The other ramification of increased short-term borrowing costs is that they might force lenders to cut back on lending, which would have an adverse effect on the global economic recovery.

Are you bearish or bullish on interest rates?  Let us know in the comments section below.