I have read and heard several comments suggesting that the increase in the 30-year fixed-rate mortgage (FRM) this year has been a direct result of the increase in the Federal Reserve’s Fed Funds rate (FF).
This is not correct.
As I will demonstrate, the FRM is determined by market forces, and in particular by the extra yield—the “spread”—which investors require when buying pools of mortgages (mortgage-backed securities, or MBS), as compared with the risk-free yield available with the 10-year Treasury note (10T), which has the nearest duration to the expected life of a pool of mortgages.
In contrast, the FF is the rate that banks use when setting their prime rates. When the FF increases, banks increase their prime Rates and therefore the interest rate on those loans whose rates are based upon Prime Rates – e.g. credit cards and auto loans.
And we will see that the FRM increased this year long before the Fed started to increase the FF rate.
Mortgage-backed securities (MBS)
A conventional mortgage or conventional loan is any type of home buyer’s loan that is not offered or secured by a government entity. Instead, conventional mortgages are available through private lenders, such as banks, credit unions, and mortgage companies.
Most conventional mortgages are packaged into mortgage-backed securities and sold to investors. This allows the bank or originator to use its capital to finance more mortgages.
The relationship between 10T and FRM
This first chart above shows how the two have moved in lockstep over the last 30-plus years.
While the “spread” has mostly been in the 1.5 to 2 percent range, it has fluctuated, especially during times of financial stress or uncertainty:
During the great recession at the end of the sub-prime mortgage boom, home prices dropped sharply. Fearing that some mortgages would not be repaid in full, MBS investors demanded a higher yield to compensate—they hoped—for the extra risk, and the spread increased to 3 percent.
The increase in the spread in the early months of the COVID-19 outbreak was caused by a different dynamic. In order to ensure the continued functioning of financial markets, the Federal Reserve slashed interest rates close to zero and at the same time embarked upon a massive buying program for both Treasury securities and MBS.
The yield on Treasuries was driven down more than on MBS, leading to an increase in the spread to 2 3/4 percent.
At the beginning of 2022, the spread was 1.6 percent, well within its historic range.
The spread then increased to 2 percent in March, to 2.6 percent in June and by October it had reached 3 percent, which means that the FRM was 1.4 percent higher than it would have been had the spread been the same as it was at the beginning of the year.
There is, unfortunately, no simple answer as to why the spread has increased so dramatically in 2022, but some of the factors include:
- fears of a recession and the impact that may have on home prices;
- the unpredictable volatility in interest rates (as an example, until very recently some financial analysts were predicting that the yield on 10T would reach 5 percent—and then two reports hinted at an easing of inflation and the yield dropped back under 4 percent);
- the Fed’s plans to reduce its holdings of MBS (it owned 30 percent of outstanding MBS at the peak);
- the substantial drop in refinancing activity; and
- the increased cost of funds for lenders as they have to compete for deposits with the higher-yields available on CDs and Tresuries.
No correlation between FRM and FF
As the second chart shows, the FRM increased from 3 percent to 4 percent before the Fed made its first increase of just 1/4 percent. And the rate reached 5 percent before the Fed increased the FF again.
On the downside, the FRM dropped 3/4 percent in July at a time when the FF increased by 3/4 percent.
And finally, in the last two weeks, the FRM has dropped by 1/2 percent with no change in the FF rate and with expectation of a further increase in the FF rate in December.
When will mortgage rates drop?
We have already seen a drop of 1/2 percent in the FRM, but the spread remains elevated at around 2.8 percent.
History gives us every reason to believe that the spread will eventually drop, and the FRM with it, even if in this unpredictable year timing is more guesswork than analysis.
For the past 10 years, Andrew Oliver, a market analyst with Team Harborside, has been the author and curator of OliverReportsMA.com, a real estate blog focused on Marblehead and the North Shore.