Mortgage rates are determined based on a spread against the ten year treasury bond. A treasury bond is considered "risk free" in terms of default because it is issued by the federal government of the United States, which historically has been considered the most likely entity in the world to pay back what they owe.
Thus the ten year bond is the benchmark and the current "spread" in the open market, or what you pay above the ten year bond, is how your mortgage rate is determined. Historically this spread has been between 1.5% to 2%.
This means that if the ten year yield is 1.85% (it is as of this morning), in a normal lending environment you would pay between 3.35% to 3.85% on your mortgage. Something very interesting has happened since the financial crisis hit in 2008.
The mortgage market in America has essentially become nationalized or government owned. Close to 100% of the loans that are created today are either purchased or insured by a government entity (FHA, Fannie, Freddie). In addition, the Federal Reserve began buying these government owned mortgages during their first QE program, further reducing the risk to everyone in the market.
In anticipation of the coming announcement of QE3 investors have been heavily purchasing mortgage bonds in the open market. As they purchase bonds, demand for bonds rises, and the rates on bonds fall. This has had the effect of bringing the spread down from over 1% in June to just .22% as of this morning.
This means there is essentially no difference in the price of a mortgage bond vs. a treasury bond in the open market. They are considered equal in terms of risk. This shows the current level of insanity in the financial world we live in today. It is obvious to even a 6 year old child that someone borrowing money for 30 years on a home is far, far, more likely to default on that debt than the federal government of the United States.
The next question is, how low can mortgage rates go? With the Fed saying they plan to purchase $40 billion (or more if needed) mortgage bonds per month forever and there being a limited supply of mortgage bonds in the world, it is possible that the interest rates on mortgage bonds in the US could move well below the rate on treasury bonds and even begin to approach zero.
Can you see the lunacy in this situation?
At some point in the future the Fed will have to tighten monetary policy. In order to tighten, they must do the opposite of what they are doing today. Instead of purchasing bonds in the open market and flooding the system with cash, they sell bonds into the market and sop up the cash.
What is going to happen to the interest rate on mortgage bonds when the Fed must become a seller? The exact opposite of what is happening today; investors will front run the Fed by selling into the market instead of buying. What will happen to the rates on mortgage bonds if the government stops purchasing and insuring 99% of all new mortgages created? The exact opposite of what is happening today as mortgage originators knowing they cannot offload the toxic mortgages to the taxpayer will tighten their lending requirements significantly. The current mortgage program in America today would make any communist country blush with jealousy.
The Fed always tells us it can sell their assets back into the market in a matter of minutes if inflation begins to run out of control. The problem is that when the market anticipates this selling they will dump mortgages into the market. This will significantly reduce the value of the Fed's holdings as their mortgage bonds become under water (ironic isn't it). They will be trapped with no way to sop up the liquidity.
That part of the story is a long way away, but it is important to think about today when making investment decisions.