Tariffs, the Trade Deficit, and the Budget Deficit.
Tariffs, the Trade Deficit, and the Budget Deficit. All three of these are interrelated, and each of these will have an impact on which way mortgage rates will go in 2025.
Tariffs. Tariffs can be a very effective method to negotiate improved trade relationships, and how much they could impact consumer prices depends on how long they are in place. It is possible that the mere threat of tariffs or having them in place for just a few months could result both nations quickly reaching an agreement for a more balanced trade relationship. The impact to consumer prices would be short lived, and a short-term increase in inflation rates would have minimal impact on long term interest rates, such as 30-year fixed rate mortgage rates.
How long tariffs remain in place depends on which nation experiences the most economic harm, and which nation is best able to switch their imports or exports to another nation. The nonpartisan Peterson Institute for International Economics estimates that a long-term trade war between the U.S. and Canada and Mexico would result in a short-term increase of inflation in the U.S. of 50 basis points for 12 months, then only 25 basis points for months 13-24, and then a zero impact to U.S. inflation rates after 24 months.
However, they estimate that Mexico would see a sharp increase of about 2.25% in the first year and they would see increased inflation due to tariffs for the next seven years. Canada would see an increase in inflation of more than 1.5% in the first year and this would then gradually decrease over the next four years.
In a tariff war, the sharp inflation increases to Mexico and Canada, would cause significantly more harm to them than a tariff war would create to the U.S., and this would increase their motivation to reach a more fair-trade agreement. The markets view that Mexico and Canada would be almost certain to have each have recessions if a tariff war continues on for 2025.
Increased inflation rates, especially expectations for future inflation rates, directly drive-up long-term interest rates.
Trade Deficits. Both Mexico and Canada place more tariffs on U.S. goods then the U.S. imposed on their goods. As of 2023 data, the U.S. has an annual trade deficit of $150 billion with Mexico and over $60 billion with Canada. Whenever two nations have a trade imbalance, the nation with the trade deficit must send the equivalent amount of cash to the nation with the trade surplus. Nations like Mexico, Canada and China which have large annual trade surpluses with the U.S. are receiving almost $500 billion annually in U.S. dollars which they then use to buy our Treasury bonds or buy our assets like real estate.
If trade deficits shrink, that puts less U.S. dollars in the hands of foreign nations, which could reduce their ability to buy U.S. Treasury bonds. Less demand for bonds pushes their prices down, which mathematically pushes up bond yields or interest rates.
Budget Deficits. Every penny of the U.S. budget deficit requires the Treasury Department to issue bonds to finance the deficit. An increased supply of bonds issued pushes down their prices, which pushes up interest rates.
The annual budget deficit is a function of total government spending, compared to total tax revenue received. If the economy grows, and stock market prices increase, this generates increased tax revenues on increased business profits and increased capital gains taxes paid on stock sales. The increased tax revenue will help shrink the budget deficit. If the Trump administration can make material cuts in government spending, this will also help reduce the annual budget deficit.
A shrinking budget deficit will reduce the supply of Treasury bonds issued by the U.S. and reduced supply pushes bond prices higher and pushes interest rates lower.
Adding it All Up. The markets do expect that Federal spending will decline, but it is not clear to the markets if the U.S. economy will grow or have a recession over the next two years, so it is hard to estimate the tax revenue side of the budget deficit equation. Even if the Federal budget deficit does decline over the next two years, will this be offset by less foreign purchases of U.S. Treasury bonds if trade deficits worldwide become more balanced?
Inflation will also have a significant impact on long term interest rates. Generally, when economies expand, this drives inflation rates higher. Government spending also creates an upward pressure on the prices of goods and services, so a reduction in government spending would create a downward pressure on inflation. Tariffs will have an upwards pressure on inflation that could be a minor speed bump, or could have a longer-term impact depending on how long tariffs are in place and how quickly the U.S. could shift our imports from China, Canada and Mexico to other countries?
The key is that it is a very difficult time for MBS bond market investors to attempt to predict future levels of inflation rates, and the supply and demand for MBS bonds, due to the uncertainty to the above factors that impact bond prices. As a result, will continue to see much higher levels of daily MBS price volatility than normal, and this could continue for at least the next six months.
Best Strategy in Times of Economic Uncertainty. The ability for a homebuyer to lock in their interest rate while they are in application for a mortgage, and their ability to lock in an interest rate for 30-years, provide incredibly protection to a person against rising interest rates both during their time of the application, plus their next 30 years of home ownership.
Locking rather than floating is a very sound strategy in times of increased market volatility.
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