Mortgage Rates Respond To A Rapidly-Devaluing U.S. Dollar

Monday, September 23, 2008 Wall Street made its verdict in the case of Government vs The Credit Markets, a knock-down, drag-out fight that may have ended last Friday.

Government wins, but not without inflation.

To an economist, inflation is the general increase in the price of everyday goods and services that occurs over time. It's an accurate description, but in the context of the government's actions of the last two weeks, we can get a better sense of what's impacting mortgage rates if we take that definition and reverse it.

Reversed, inflation is the devaluation of a currency, so more of said currency is required to buy the same quantity of everyday goods and services.

It's the latter interpretation that's driving Wall Street this week.

Investors assume that the government will have no choice but to print more money to service its debts, thereby diluting the dollar's value. Because there's more of them, after all, each dollar is worthless worth less.

This is sometimes called "monetary supply inflation" and concerns about it caused the U.S. dollar to fall 2.4 % versus the Euro yesterday -- the biggest one-day drop in history.

Dollar weakness then spilled over into the commodity market because all of the instruments are priced in U.S. dollars. Oil prices jumped $25 per barrel at one point before settling in a tad lower. This, too, was the biggest one-day movement in history.

And lastly, the mortgage market got hit. Because mortgage bonds are repaid in U.S. dollars, the value of those repayments dropped. This forced mortgage rates higher because the only way to entice investors to buy devalued mortgage-backed bonds is to offer them with a higher interest rate.

If you're wondering why conforming mortgage rates are up by 0.750% since last week, this is it -- it's because mortgage rates are responding to the expectations of a weaker dollar going forward. This is the reverse of what happened in August.

So far, non-conforming mortgages including jumbo and super jumbo loans are unaffected.