Before You Start Shorting Homebuilder Stocks…

March 6, 2003
Edward Allen

Yesterday, part of
my column focused on US treasuries, and I touched on some factors that
may indicate the market is approaching overbought
levels. Today, I’d like to take my discussion a step further and examine one of
the implications of a correction in the US treasuries, particularly in the 10
year note.

As many investors know, there is a pretty strong
correlation between the yield on certain Treasury notes and mortgage rates. The
reason for this strong relationship is that individual mortgages are bundled
together and then issued out as bonds in the financial markets; and like most
bonds, these issues, which are known as mortgage-backed securities, are priced
relative to the risk-free interest rates paid on government debt. The rates on
mortgage-backed securities are most sensitive to those on the 10 year notes because
most 30-year mortgages are paid off in 10 years. So, if there is a correction in
the 10 year note and mortgage rates move with it, the market can expect the
housing market to contract–right? Not quite. Many potential buyers delay
purchasing their homes until mortgage rates bottom out, but this can’t be
confirmed until rates start to turn around. As a result, once mortgage and
Treasury rates turn around, there may be one last surge in home purchases, and
homebuilder stocks will move back up in false anticipation of continued
strength.Â