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U.S. mortgage watchers worry about China FX move
Updated: 2006-01-11 09:11

China's recent signal that it may diversify its foreign investments in 2006 has mortgage industry watchers concerned that if China buys fewer U.S. Treasury securities this year, it may drive interest rates higher and pour more cold water on the real estate market.

Last week, China's foreign currency regulator said its plans for 2006 include "actively exploring more efficient use of our FX (foreign-exchange) reserve assets" and "widening the foreign exchange reserves investment scope."

While China's central bank said Tuesday it has no plans to sell dollars from its $800 billion-plus foreign reserves, some analysts predict China may buy less U.S. government debt at Treasury auctions this year.

Like Japan, China is a large buyer of U.S. Treasuries and other U.S. debt such as securities issued by housing agencies Freddie Mac and Fannie Mae. China sees the U.S. debt market as stable and liquid versus other countries' debt and its purchases have helped keep U.S. interest rates relatively low in recent years.

While it is not certain exactly how a drop in China's demand for U.S. government debt would show up, Ken Hackel, chief fixed income analyst at RBS Greenwich Capital Markets, believes there could fewer purchases of five- and 10-year U.S. government notes at regular U.S. Treasury auctions.

As a result, "there may be somewhat higher yields ... over time," Hackel said. He added that China likely won't completely exit the U.S. government debt market, but merely pare back its buying.

Home mortgage rates are closely tied to Treasury rates and any rise in the cost of borrowing could further slow home sales. A series of increases in the overnight bank lending rate by the Federal Reserve since 2004 has already made adjustable-rate mortgages more pricey. Further rises in the yield of 10-year Treasury notes, which lenders use as a benchmark for rates they charge for 15- and 30-year fixed-rate mortgages, could make those mortgages more expensive as well.

Last week, 30-year mortgages averaged 6.21 percent, up from 5.77 percent a year ago, according to Freddie Mac.

"If it comes to pass that long-term Treasury yields are higher, that means that mortgage rates will become more expensive for consumers," said Frank Nothaft, chief economist at Freddie Mac, one of two housing agencies chartered by Congress to help lenders resell their mortgages on Wall Street.

"The added burden of a rise in interest rates, even a small one, is of no help" to consumers or their lenders, said Keith Gumbinger of HSH Associates, which tracks mortgage rates.

While China has signaled a shift in its buying patterns, it likely won't completely abandon U.S. dollar denominated assets like debt issued by Fannie Mae and Freddie Mac.

"They (China) ship a lot of goods to Wal-Mart. Wal-Mart pays for these goods in dollars and manufacturers in China trade these for China's local currency and eventually the dollars work their way into China's central bank," said Chris Low, chief economist at FTN Financial.

China's central bankers have a choice of investing the U.S. currency in dollar denominated assets like U.S. Treasury bonds or they can trade the dollars for other currencies.

"If they diversify from the U.S. dollar denominated assets, it would lower the value of the U.S. dollar relative to China's currency, the yuan, and make it more expensive for American companies to buy goods made in China," said Low, adding that he does not expect China let its currency rise in value by selling U.S. dollars.

Nothaft and Hackel also point out that any drop in demand from China could be made up for by investors like U.S. brokerage firms or foreign investors, containing a rise in U.S. interest rates.

While mortgage rates today are up from their record lows, they are still much lower than the double digit rates seen in the 1980s. But there are signs that higher borrowing costs already are weighing on sales.

The National Association of Realtors said last week its measure of sales contracts signed in November dropped 2.5 percent, a third consecutive decline. On Tuesday, The association said it expects the 30-year fixed-rate mortgage to rise gradually to 6.7 percent during the second half of the year.

While Hackel believes the change in China's buying of Treasuries should result in a marginal increase in mortgage rates, David Olson of Wholesale Access, a firm that tracks the mortgage banking industry, believes mortgage rates could be as much as half a percentage point higher.

"I don't think they (China) are going away completely, but if they do then we're going to have quite a runup in rates," said Olson.

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