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Predicting Mortgage Rates

Historically, treasury bonds have been considered one of the most secure investments that can be made – especially in a country with a stable government such as Australia. The bond holder is almost guaranteed to receive half-yearly coupon payments plus all their principal once the maturity date is reached. Treasury bonds can therefore be considered a risk-free asset and the yield received is the risk-free rate for investment. For a bank giving out a home loan, the interest rate charged usually depends on the risk-free rate plus the risk premium, determined by the likelihood of the borrower to repay his loan.

We’d expect the average mortgage rate and treasury bond yield to behave similarly – that is, when bond yields increase, so should the mortgage rate, and vice versa. When we looked at the average variable mortgage rate and 10 year treasury bond yields in Australia, both move up and down in the same direction, although not always at the same time.

However, when you compare current variable mortgage rates with 10-year treasury bond yields from 8 months ago, we see that a strong relationship exists (see Fig.1). What this means is that we can now estimate the mortgage rate 8 months from now (September 2016).

Fig1

To do this, we used the standard deviation of the difference between the two variables to set up an upper and lower bound. This is the prediction band (in orange) and it shows the range in which 96.3% of mortgage rates are likely to be between. Using this band, Fig. 2 shows the current (in blue) and predicted average variable mortgage rate until September 2016.

Fig2

In September 2016, the middle point of the band is 4.5%. However, this does not mean the variable mortgage rate will fall by 0.85% in the next 8 months. Where the actual rate will end up is very much dependant on other factors such as unemployment and average income. Due to the recent trend of mortgage rates to be near the top end of the band, it is very likely the average variable mortgage rate will remain near its current position. If it does change, it is much more likely to fall than to rise further.

Using this model, Secret Agent predicts the average variable mortgage rate to remain flat until September 2016, staying between 3% and 6% and most likely holding above 5%.

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