The psychic at the county fair could give you an outlook on mortgage rates - and she might even turn out to be right. But over-reliance on a crystal ball gazer probably isn't the best fiscal strategy. You're better off learning about the factors that influence mortgage rates, such as inflation risk.

In October 2008, the U.S. inflation rate dipped below 4 percent. Two months later, the average 30-year mortgage rate as reported by Freddie Mac dipped below 6 percent. In August of 2010, neither rate has risen above those levels. Are these continued low inflation and mortgage rates coincidental? Not exactly. There's a connection between inflation rates and mortgage rates. But to grasp that connection, you must learn a bit about how the mortgage industry is funded.

Mortgage rates move with bond rates

Many mortgages are pooled and sold off to investors as securities. The money generated by these sales is channeled back to lenders and used to fund more mortgage loans. These securities provide the investor with a recurring stream of interest and principal payments, just like a bond. The yield earned by investors is driven by the mortgage rate that's charged to homeowners. Essentially, mortgage-backed securities (MBS) are an alternative for investors who want to earn fixed income. In order for MBS to be interesting to investors, though, the yields must be competitive to other types of bonds. If MBS yields are too low, no one will buy them. Complicating this dynamic is the underlying demand for mortgages. If mortgage rates are too high, of course, demand for mortgages will decline.

How inflation influences bond rates

Inflation, the rise in prices over a period of time, reduces the buying power of the dollar. When inflation is high, the income earned by bond investors has less value, because its purchasing power has been reduced. Therefore, fixed-rate bonds tend to be less attractive to investors during periods of high inflation. A decline in bond demand creates a decline in bond prices. Bond yield is a function of the price and the stated interest rate on the bond; thus, a decline in its price leads to an increase in its yield.

As noted above, MBS yields and mortgage rates tend to move with bond yields. Since inflation rates impact bond yields, they also impact mortgage rates.

Outlook drives the market

The link between inflation and mortgage rates gets even more complex when you consider that the outlook of the investment community has a strong influence of its own. If investors believe an inflationary trend is just around the corner, bond and mortgage rates will likely react - before inflation actually kicks in. Likewise, if investors believe the risk of inflation will be low for the foreseeable future, it puts downward pressure on bond and mortgage rates.

What does this mean to you? The Fed's inflation outlook has shifted lower in recent months. Such an outlook predicts continued low mortgage rates, at least until investors have a reason to believe otherwise. This is good if you have a mortgage loan in your future. Let's hope that the central bank's prediction has more behind it than tarot cards and a crystal ball.

Published on August 18, 2010