One driver of interest rates is credit quality or risk of default. Even though underwriting can mitigate this, someone with worse credit quality has a higher chance of default. Investors will demand a higher rate of interest to compensate them for taking on the added risk of default due to poorer credit quality.

 

The other and more important driver of interest rates is inflation. Inflation is the archenemy of Bonds since Bonds pay investors a fixed rate of return over time. Inflation erodes the buying power of your future fixed return because the cost of goods and services has increased. Meaning that fixed amount received will purchase less in the future.

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But what is inflation? Inflation is too many dollars chasing too few products, which causes prices to be bid higher. If there is an item with high demand, such as a home on the market that has a lot of potential buyers, the high demand will drive the price of that home higher.

 

Deflation is the opposite. Deflation is where there are too many products and not enough buyers, which drives prices lower. If you have 10 homes for sale on one block and only a handful of interested buyers, there are too many products competing for too few dollars. If you have a large inventory that is not moving, you tend to lower the price to increase demand, which contributes to deflation.

 

If inflation is rising, Mortgage Bond investors must be compensated with a higher rate of return to combat the erosion of the Bond’s fixed payment, causing Mortgage Rates to rise. As a result, inflation reports are followed closely.

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