Rationalization: Low Rates Justify High Valuations

The “rationalization” that low rates justify high valuations is but one of several arguments used to justify overpaying for value in a late-stage bull market.

As discussed previously, one of the “bullish spins” for the market has been that “earnings are cheap” based on 2- and even 3-year forward estimates. As noted in “Justifiable Bullishness Or Is It Willful Blindness?“:

In 2020, investors are again chasing “growth at any price” and rationalizing overpaying for growth. Such makes the mantra of using 24-month estimates to justify paying exceedingly high valuations today, even riskier.”

Such is also why there is the most significant disparity between growth and value on record.

This Time Is Different

The belief that this time is different from the past has always been the most dangerous of phrases for investors. However, this is where participants exist today. While it is true the excessive monetary liquidity has certainly changed short-term market dynamics, there is no evidence that it has mitigated long-term consequences.

Moreover, investors are also relying on the belief that low interest rates justify overpaying for earnings and sales.

“Valuations don’t matter as much as they did in the past because ‘this time is different’ in that interest rates are so low.”

The basic premise of the interest rate/valuation argument has its roots in the “Fed Model” as promoted by Alan Greenspan during his tenure as Federal Reserve Chairman.

The Fed Model states that when the earnings yield on stocks (earnings divided by price) is higher than the Treasury yield, you invest in stocks, and vice-versa. In other words, disregard valuations and buy yield.

There is a critical disconnect that needs to be understood.

Earnings Yield

You receive the income from owning a Treasury bond. However, there is no tangible return from the earnings yield.

For example, if I own a Treasury bond with a 1% coupon and a stock with a 2% earnings yield, if the price of both assets doesn’t move for one year – my net return on the bond is 1%, while the net return on the stock is 0%.

Which one had the better return from 2000 to the present?

Yet, analysts keep trotting out this broken model to entice investors to chase an asset class with substantially higher volatility risk and lower returns.

Low Rates Don’t Justify High Valuations

An offshoot of the Fed Model to rationalize overpaying for assets is that low interest rates justify high valuations.

However, is the recent decline in interest rates, driven by massive global Central Bank interventions, really providing valuation support? The premise is that cheaper borrowing costs boost bottom line earnings. The problem is that over the last decade, low rates have led to a deterioration in economic growth and prosperity.

The chart below takes the interest rate argument from a little different angle. I have capped interest rates from their “low point” of each interest rate cycle to the next “high point” and then compared it to the S&P 500 index. (The vertical dashed lines mark the peaks in the S&P 500 Index.)

In the majority of cases, the market tends to peak between the low point interest rates for each cycle and the next high point. In other words, a period of steadily rising interest rates is not conducive to higher equity prices.

Discounting The Discount

The primary argument is that when inflation or interest rates fall, the present value of future cash flows from equities rises, and subsequently, so should their valuation. While true, assuming all else is equal, a falling discount rate does suggest a higher valuation. However, when inflation declines, future nominal cash flow from equities also falls, and this can offset the effect of lower discount rates. Lower discount rates are applied to lower expected cash flows.

In other words, without adjusting for inflation and, in no small degree, economic growth, suggesting low rates justify overpaying for cash flows is a very flawed premise.

“Instead of regarding stocks as a fixed-rate bond with known nominal coupons, one must think of stocks as a floating-rate bond whose coupons will float with nominal earnings growth. In this analogy, the stock market’s P/E is like the price of a floating-rate bond. In most cases, despite moves in interest rates, the price of a floating-rate bond changes little, and likewise the rational P/E for the stock market moves little.

– Cliff Asness

Historically, when interest rates or infla­tion are low, the stock market’s E/P is also low, as shown in the chart above.

But when isolating the times when interest rates were meager, that has occurred twice; in the 1940s and currently. In the 1940s, stock valuations were low, along with interest rates. Therefore, the statement that low interest rates cause high valuations is a .500 batting average, which is the equivalent of a coin-flip.


  • Exceptionally high interest rates, which have occurred twice, coincided with low stock market valuations. This fact does not prove that high interest rates “cause” low stock valuations. But at least the historical record is consistent with such a statement.
  • Extremely low interest rates, which have occurred twice, have coincided with high stock market valuations only once: today. The historical record (1/2 probability) does not validate the highly confident mainstream narrative that low interest rates “cause” or extremely high stock market valuations.
  • Extremely high stock valuations have occurred three times. Only once (1/3 probability) did high stock valuations coincide with low interest rates: today.
  • If extremely low interest rates do not cause extremely high stock market valuations, then a rise in rates should not necessarily cause a decline in stocks. That is, the historical record does not support the near-certain mainstream narrative that an increase in rates will torpedo stock prices.
  • To demonstrate the ability of a consensus narrative to overwhelm analysis of historical facts and even current reality, consider that the Fed has hiked short-term interest rates five times since December 2015. Also, long-term rates bottomed in mid-2016 and have moved more than a full percent higher. Yet, the S&P 500 index has risen more than 30% since the lows in short-term and long-term rates.

As noted in “Why This Isn’t 1920. Valuations & Returns,” the highest correlation between stock prices and future returns comes from valuations.

Rationalization Low Rates, Rationalization: Low Rates Justify High Valuations

Forward Returns Suffer

There is little support for the statement that low rates support high valuations, as noted by Cliff Asness previously.

So, when pundits say it is a good time for long-term investors to buy stocks because interest rates are low, and then show you something like chart above to prove their point, please watch the tense of what they say, as what they often really mean is that it was a good time to buy stocks ten years ago, as investors are now paying a very high P/E for the stock market (perhaps fooled into doing so by low interest rates as I contend), and the story going forward may be painfully different.

– Cliff Asness

The last point is crucially important. The chart below compares earnings yield (inverted scale) to forward 5-year real returns. When E/Y has been near current levels, the performance over the next 5 years has been quite dismal.


It is imperative to remember valuations are very predictive of long-term returns from the investment process. However, they are horrible timing indicators.

Beware the investment advisor, pundit or superstar investor who is sure that extremely low rates cause incredibly high stock valuations. Or, that a rise in rates from extremely low levels will cause a decline in stock prices. Stocks may fall, and interest rates may rise, but the historical record disagrees that one causes the other.

There is much to debate about the current level of interest rates and future stock market returns. However, what is clear is the 40-year decline in rates did not mitigate two extremely nasty bear markets since 1998, just as falling rates did not mitigate the crash in 1929 and the subsequent depression.

Do low interest rates justify high valuations?

History suggests they don’t.

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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CAD/JPY – Playing Unequal Recovery Rates

Differences in effects from the stimulus in Canada and Japan

Many experts admit that Japan’s central bank has even less economic stimulus tools at its disposal than the US Fed. In fact, in this country, we see almost permanent support for the economy, which suggests that the effect of stimulus has reached its limit.

That is especially the case given several historical precedents over the past few decades where large-scale fiscal stimulus in Japan has failed to generate a self-sustaining recovery that keeps Japan’s economy close to or above its potential growth rate for an extended period.

– “How Quickly Will Japan’s Economy Bounce Back?” Wells Fargo Securities Economics Group, August 21, 2020.

Unlike the United States, which spent $2 trillion to support its economy, but where the increase in the number of coronavirus cases this summer (about 60-80 thousand people per day) negated the effect from the stimulus program, the Japanese government allocated $2.2 trillion to support the economy and its “V”-shaped recovery. Until now, even despite the absence of a large number of infected people (less than a thousand people per day), the effect of stimulus in this country remains very modest.

Daily COVID-19 cases in the US as of August 27, 2020

(Source: Johns Hopkins University)

Daily COVID-19 cases in Japan as of August 27, 2020

Daily COVID-19 cases in Japan as of August 27, 2020

(Source: Johns Hopkins University)

Daily COVID-19 cases in Canada as of August 27, 2020

Daily COVID-19 cases in Canada as of August 27, 2020

(Source: Johns Hopkins University)

Altogether, taking into account not only quantitative easing but also fiscal incentives, as well as loans and guarantees, the size of the stimulus program in Japan exceeds 60% of this country’s GDP. In the United States, this figure is less than 30% of GDP (see the chart below).

The size of economic stimulus in different countries, % of GDP

The size of economic stimulus in different countries, % of GDP

(Source: “The coronavirus and economic policy measures: an overview,” Nordea Markets, August 21, 2020)

Canada also spent about 25% of its GDP on fostering economic growth. But here, unlike the United States, an increase in the number of COVID-19 cases did not offset the effect of the economic recovery program. So here, we see more obvious benefits to the economy.

Canada: Sharper bounce from the bottom

You should also be aware of the fact that due to the low incidence of coronavirus infections, the Japanese government introduced less stringent restrictive measures, which in theory should have positively affected its economic performance. However, in reality, this did not happen. All key economic indicators in Japan plummeted in the second quarter of 2020 by an amount comparable to the United States and other countries that were more severely affected by the infection.

Industrial production has not given any clear signals yet. After a significant decline in April and May, June data entered a positive trajectory. However, June and July data may be positive due to the effect of pent-up demand. Therefore, the indicators for August will be of primary importance. Their preliminary readings will be available on September 29 (according to the FXStreet.com economic calendar). Reportedly, the rebound in industrial production in Canada is sharper than in Japan.

Japan’s industrial production (MOM)

Japan’s industrial production (MoM)

(Source: FXStreet.com)

Canada’s industrial production (MOM)

Canada’s industrial production (MoM)

(Source: TradingEconomics)

Another important indicator for the Japanese economy is data on export, which makes up 19% of the country’s GDP. As in the case of industrial production, we are interested in the data for August, which will be available on September 15 (according to the FXStreet.com’s economic calendar). Comparing the nature of the decline and recovery of export orders, we can conclude that the fall in Canada was more rapid. Only the April figures contributed to the fall from $46.43 billion in March to $32.45 billion in April, followed by a sharp rebound in May and June. In Japan, the decline lasted three months from March to May, and only in June and July, we began to observe recovery.

Japan’s exports (YoY)

Japan’s exports (YoY)

(Source: FXStreet.com)

Canada’s exports (YoY)

Canada’s exports (YoY)

(Source: FXStreet.com)

Manufacturing PMIs for Japan and Canada

Manufacturing PMIs for Japan and Canada

(Source: Trading Economics)

Note: Manufacturing PMI data for Japan is on the right axis; manufacturing PMI data for Canada is on the left axis.

The Manufacturing PMI shows that business confidence in Canada has almost completely recovered to pre-crisis levels, while data in Japan still cannot cross the 50-point threshold.

Searching for confirmation of a faster recovery in Canada

The tensions in relations between China and the United States and the unresolved issue with a vaccine against coronavirus infection provided the primary support for the yen. Moreover, judging from the reaction of the foreign exchange market participants, after the announcement of the pandemic, the yen was a safer currency than even the US dollar.

USD/JPY exchange rate, daily time frame

USD/JPY exchange rate, daily timeframe

(Source: TradingView)

The fact that the USD/JPY exchange rate is now depreciating is mainly due to the general weakness of the US dollar as a global reserve currency, caused by the new round of quantitative easing in the American economy.

However, these factors serve more like a background. In crosses with risky currencies, for example, with the Australian dollar, we see that the yen is declining. The Aussie has already won back the entire drop caused by the March flight into safe haven currencies. The New Zealand dollar is also close to this.

AUD/JPY and NZD/JPY exchange rates, daily time frame

AUD/JPY and NZD/JPY exchange rates, daily timeframe

(Source: TradingView)

The Canadian dollar is not one of the currencies that are sensitive to risk, so its exchange rate against the yen, although showing similar dynamics, has not yet returned to pre-crisis levels. If we pay attention to the monthly chart of the exchange rate of the Canadian dollar against the yen, we will see that the historical support level of 75.00 remained intact this time. Given the current market situation, it seems unlikely that the price will be able to reverse and break it down. Therefore, the most probable trajectory of its further movement will be further growth.

CAD/JPY exchange rate, monthly time frame

CAD/JPY exchange rate, monthly timeframe

(Source: TradingView)

In Wells Fargo’s latest study (linked above), its authors point out that the recovery of the Japanese economy should begin to gain momentum in the third quarter. But in fact, we must consider the speed and nature of this recovery.

If you look at Canada, its economists draw a realistic scenario for the further development of the economy of this country. In its latest Monetary Policy Report, the central bank of Canada published its forecast for the country’s economic recovery, which looks like this:

Recovery in Canada

(Source: Monetary Policy Report, July 2020, Bank of Canada)

It also said that it “[…] expects a sharp rebound in economic activity in the reopening phase of the recovery, followed by a more prolonged recuperation phase”.

If we add a time frame to this general form of recovery, we see that the central bank of Canada expects economic activity to return to pre-crisis levels only in 2022.

Recovery in Canada, forecast

(Source: Monetary Policy Report, July 2020, Bank of Canada)

Thus, now we are just entering the recuperation phase. Japan’s central bank also expects a moderate recovery, according to its reports.

Japan’s economy is likely to improve gradually from the second half of this year with economic activity resuming, but the pace is expected to be only moderate while the impact of the novel coronavirus (COVID-19) remains worldwide.

Outlook for Economic Activity and Prices, July 2020, Bank of Japan, July 16, 2020.

In the case of Japan, it seems more likely that the initial reopening phase and the recuperation phase will look the same, representing a single low-slope solid curve rising to pre-crisis levels. In this case, the recovery process will be even longer in time.

As for the problem with the coronavirus, traders are already starting to price in the probability of vaccine development. According to Hypermind, which trades contracts for a COVID-19 vaccine, the most likely outcome is that it will be available after the first quarter of 2021.


In this regard, it is likely that, unlike risk-on currencies, the Canadian dollar will take longer to rise against the Japanese yen. In particular, traders are waiting for confirmation of the hypothesis of a faster and more sustainable recovery of the Canadian economy compared to the Japanese economy, which should be confirmed by future data. If economic data for August-September prove this hypothesis, traders are likely to bet more confidently on the Canadian dollar. Another factor supporting the Canadian dollar will be investors repricing the probability of a coronavirus vaccine development, which could weaken the demand for safe haven currencies.

CAD/JPY exchange rate, daily time frame

CAD/JPY exchange rate, daily timeframe

(Source: TradingView)

Using technical analysis, we do not exclude the possibility of a decline in CAD/JPY to the level of 78 and resumption of growth after that. However, the baseline scenario will be the growth of the pair to the resistance level of 82 and its successful breakout.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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The mistakes to avoid when moving to a state with lower taxes and why low mortgage rates are a double-edged sword

Hi, MarketWatchers. Don’t miss these top stories:

Personal Finance
Thinking about moving to a state with lower taxes? These are the mistakes to avoid

Some states are great to live in, but not so great to die in.

32 states have been approved to offer $300 extra in unemployment benefits — only 4 have started to distribute it

An executive order President Donald Trump signed Aug. 8 calls for distributing an additional $300 in weekly unemployment benefits from a $44 billion fund set aside for disaster relief.

My sister-in-law moved in with her mother, changed her will and inherited everything. Is it too late to claim what belongs to us?

‘She is a compulsive liar and has not been honest about anything concerning the trust. There is talk about elder abuse.’

Sweden embraced herd immunity, while the U.K. abandoned the idea — so why do they BOTH have high COVID-19 fatality rates?

‘Sweden’s prized herd immunity is nowhere in sight,’ according to the Journal of the Royal Society of Medicine.

Google searches for ‘panic attack,’ ‘anxiety attack’ hit all-time high during coronavirus pandemic

Queries appeared to surge in response to social distancing orders and early pandemic milestones.

‘We can get through this’: How to manage your mental health during the COVID-19 pandemic

Salesforce CEO Marc Benioff revealed this week that about one-third of the company’s employees had reported experiencing a mental-health issue.

‘A toxic scandal’: Ireland becomes a test case on how NOT to battle COVID-19

Ireland’s EU Commissioner for Trade resigned late Wednesday after reports alleging that he did not abide by the rules of his 14-day quarantine period, in addition to attending an 81-person dinner, also directly contravening government guidelines

Mortgage rates fall once again — but rising home prices mean that buyers shouldn’t expect savings

Even with interest rates at record lows, someone buying the typical home today will have a larger monthly mortgage payment than they would have if they bought a year ago.

Pending home sales rise in July, but inventory challenges could limit the housing sector

Compared with a year ago, contract signings were up 15.5%.

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Fed adopts new strategy to allow higher inflation and welcome strong labor markets

The Federal Reserve’s interest-rate committee on Thursday announced it has unanimously approved a new strategy seen as leading to an easier monetary policy stance.

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Woke capitalism, not racial capitalism, is the future, though it will not necessarily be any better for most people of color than its earlier, cruder version.

Opinion: We worry the FDA is under extreme pressure to rush approvals for COVID-19 treatments

The emergency use authorization for investigational convalescent plasma is just the latest example.

Moderna and Pfizer’s COVID-19 vaccine candidates require ultra-low temperatures, raising questions about storage, distribution

The COVID-19 vaccine candidates being developed by Moderna Inc. and BioNTech and Pfizer Inc. will require stringent standards for refrigeration, and that may hamper how they are distributed to the hundreds of millions of Americans expecting to receive them.

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Dow Jumps on Bets Low Rates to Persist By Investing.com

© Reuters.

By Yasin Ebrahim

Investing.com – The Dow advanced Thursday, as investors bet that market-friendly policies from the Federal Reserve will remain in place for a prolonged period after Chairman Jerome Powell said the bank would allow inflation to run hot to support the economic recovery.    

The rose 0.94%, or  266 points. The rose 0.53%, while the gained 0.11%.

Powell unveiled the long-awaited update on the Fed’s framework, saying that the central bank will take a flexible approach to targeting inflation, which it still expects to be 2% over time.  When inflation is running below 2% for a period of time “appropriate monetary policy” will be taken.

“The bottom line here is that Mr. Powell and his colleagues have given themselves significantly more room to maintain zero rates and a swollen balance sheet over the next couple of years, as the economy recovers from the Covid shock,” Panetheon Macroeconomics said.  

Financials, mostly banks, led the move higher. They would get a lift from rising bond yields, which boosts the net interest income banks earn. The hit a more than two-month high.

Bank of America (NYSE:), Goldman Sachs Group (NYSE:), Citigroup (NYSE:) were up more than 1%, while JPMorgan Chase (NYSE:) jumped 3%.

In consumer staples, Walmart Inc(NYSE:) surged 4% as the company confirmed that it would partner with Microsoft to acquire social media company TikTok.

Microsoft (NASDAQ:) was up about 3%, but that did little to stop weakness in tech as the tech giant’s contemporaries like Apple (NASDAQ:) and Google (NASDAQ:) were down nearly 1%.

Google has come under further scrutiny as the government weighs bringing antitrust suit against the search-engine giant, with reports suggesting that lawmakers are investigating whether Google selling bundled products is stifling competition.

In healthcare, Abbott Laboratories (NYSE:) surged 9% as President Donald Trump reportedly plans to unveil a $750 million deal to purchase 150 million Covid-19 tests from the company.

The news added to a wave of positive news about tests and potential vaccines at a time when the number of new cases appears to be slowing across the U.S.

Energy, however, had limited upside in the broader market as oil prices fell despite production cuts related to Hurricane Laura, which made landfall along the U.S. Gulf Coast on Thursday.

Disclaimer: Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. All CFDs (stocks, indexes, futures) and Forex prices are not provided by exchanges but rather by market makers, and so prices may not be accurate and may differ from the actual market price, meaning prices are indicative and not appropriate for trading purposes. Therefore Fusion Media doesn`t bear any responsibility for any trading losses you might incur as a result of using this data.

Fusion Media or anyone involved with Fusion Media will not accept any liability for loss or damage as a result of reliance on the information including data, quotes, charts and buy/sell signals contained within this website. Please be fully informed regarding the risks and costs associated with trading the financial markets, it is one of the riskiest investment forms possible.

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Mortgage rates keep falling — will they finally drop to 0%?

Mortgage rates have dropped to record lows on eight separate occasions in 2020 so far, as the coronavirus pandemic has roiled the global economy.

But could they eventually drop to 0%? Well, if past precedent is any indication, there’s indeed a chance.

Freddie Mac

deputy chief economist Len Kiefer posted to Twitter

a chart showing the movements in the average rate of the 30-year fixed-rate mortgage following the Great Recession. As he pointed out, interest rates on home loans dropped in four of the five years following the 2008 financial crisis, falling roughly three percentage points.

This week, mortgage rates moved up a bit. The 30-year fixed-rate mortgage averaged 2.96% for the week ending Aug. 13, rising eight basis points from the week prior, Freddie Mac reported Thursday. The 15-year fixed-rate mortgage averaged 2.46%, while the 5-year Treasury-indexed hybrid adjustable-rate mortgage stood at 2.9%. The week prior mortgage rates had fallen to a record low for the eighth time this year.

So were we to see a repeat of what happened after the Great Recession, then rates indeed would drop to 0% — or even into negative territory. Predicting whether that will happen isn’t so simple.

“Interest rates are super hard to forecast,” Kiefer told MarketWatch. “Economists, myself included, have not had a great track record of predicting where rates would go. For many years, folks were saying rates were headed higher, and they ended up continuing to head lower.”

A 0% mortgage isn’t a fantasy — in fact, it’s the reality across the pond. In Denmark, Jyske Bank

began offering a 10-year fixed-rate mortgage at negative 0.5% last year, and Finland-based Nordea Bank announced around the same time that it was offering a 20-year fixed-rate mortgage in Denmark that charges no interest.

‘For many years, folks, were saying rates were headed higher, and they ended up continuing to head lower.’

— Len Kiefer, deputy chief economist at Freddie Mac

But economists say there are many reasons to believe that mortgage rates won’t drop to 0% or lower any time soon in the U.S. For instance, Freddie Mac’s most recent forecast estimated that the 30-year mortgage would average 3.2% in 2021, not too far from where it stands now.

That’s in large part because the Federal Reserve wouldn’t likely let it happen. The Fed doesn’t directly control mortgage rates. Instead, mortgage rates roughly followed the direction of long-term bond yields, particularly the 10-year Treasury note

However, expectations regarding the Fed’s interest-rate policy are cooked into the yields for those bonds and mortgage rates. When the pandemic became a major concern, the Federal Reserve did move to cut the short-term federal funds rate to zero — and sure enough, since then both the 10-year Treasury yield and the 30-year mortgage rate have dropped to record lows.

In order for 0% mortgages to become a reality, “We’d probably have to see negative Fed funds rates,” said Danielle Hale, chief economist at Realtor.com.

“The central bank rates in Denmark had been negative for five years or so before mortgage rates got to zero,” Hale added. “The Fed has been clear that it’s not their preferred course of action.”

A lot would need to happen for the Fed to take rates negative, including perhaps a major demographic shift.

“The U.S. population is a lot younger than Europe or Japan,” Kiefer said. “Perhaps in 10 years, depending on immigration and other things, we may look more like them. If that is one of the driving factors of inflation — we don’t know that for sure, but that’s a theory — then that could be what we would perhaps look at.”

‘The central bank rates in Denmark had been negative for five years or so before mortgage rates got to zero.’

— Danielle Hale, chief economist at Realtor.com

In other words, the aging populations in Western Europe and Japan could explain the slower economic growth those regions have seen. And it would take a serious, prolonged downturn in GDP or labor market growth in the U.S. for the Fed to feel comfortable moving rates into the negative territory.

Yet, even if that happens, rates could still stay above 0% — and that’s because of the role investors in mortgage-backed securities play. “Mortgage rates are determined by investor demand for mortgage bonds,” said Matthew Speakman, an economist at Zillow

“A precipitous drop in rates would likely prompt a surge in refinancing demand, and loans that only generate a few payments before being refinanced aren’t profitable for investors,” Speakman added. “This dynamic would weaken investor demand and result in higher rates.”

Plus, mortgages carry some risk, since homeowners could miss payments and go into default. That risk comes with a premium that translates into a higher interest rate compared with the yield on the 10-year Treasury and other investments, Speakman said.

However unlikely it is that mortgage rates fall to 0% on average, that isn’t to say one or two lenders might not flirt with the idea. United Wholesale Mortgage, for instance, has begun advertising a 30-year fixed-rate mortgage at only 1.99% — though the low interest rate comes with steep fees.

“When we survey lenders we see a variety of interest rates,” Kiefer said. “It may be very beneficial for them to shop around because they may get very different quotes, depending on who they talk to.”

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