For all the hand-wringing leading up to the Fed’s first hike in the Fed Funds rate in nearly a decade, the event had little effect on the mortgage market. With more rate increases anticipated by Fed watchers over the next few years, now is a good time to revisit what exactly drives mortgage rates for borrowers. It turns out that rather than obsessing over the outcome of the next Federal Open Market Committee meeting, borrowers would be better off watching unfolding economic developments here and abroad for guidance on where mortgage rates are heading.
Although there are a number of factors driving mortgage rates, the standard fixed-rate 30-year mortgage rate can be represented as the sum of the 10-year Treasury note rate and a spread above that rate to compensate investors for taking on some additional risk. There is a strong correlation between these two rates that has held up over time and over different economic environments.
Factors that affect the yield on 10-year Treasuries will over time be reflected in mortgage rates. Two of these are inflation and economic conditions. We have enjoyed a low inflation environment for a number of years but if we had a bout of higher inflation it would lead to higher rates as investors in bonds require additional compensation for a loss in buying power. Also, long-term bond investors require a term premium that compensates them for uncertainty, and there can be a “flight to quality” to U.S. Treasuries.
Right after the Fed announced they were raising the Fed funds target rate by .25%, the effect on the 10-year Treasury rate was muted. The day after, the yield on 10-year Treasuries rose a meager .02% from 2.28% to 2.30% and hovered in that range until mid-January when the 10-year rate fell to just over 2% in the midst of new economic turmoil affecting China and a continued fall in oil prices.
This isn’t to say that what the Fed does about short-term rates is unimportant. On the contrary, the Fed’s policy for the Fed Funds rate going forward reflects a striking departure from its zero interest rate policy and many feel it reduces the chances of fueling asset bubbles. Fed policy would prefer to gently nudge the yield curve upward, but the reality may be eventual flattening as strong demand for U.S. Treasuries should limit the degree to which long-term yields will rise.
Looking at the market’s expectation of 10-year Treasury rates at year-end compared to 10-year spot rates, this rate could be expected to go up another .25%. But with China’s economic woes and that of oil markets still in doubt, the 10-year rate might not budge that much.Looking at the other component of mortgage rates, the spread between the fixed-rate 30-year mortgage and the 10-year Treasury, spreads have remained remarkably stable between the two series over time, averaging about 1.7% over the last 15 years.
The spread that we observe between these series represents the additional compensation an investor would need to be attracted to buy a mortgage-backed security over a 10-year Treasury note’s yield in this case. This compensation reflects the fact that the MBS cash flows expose the investor to something called interest rate risk, or the fact that they will receive cash flows back sooner than they would prefer due to refinancings by borrowers.
What all of this means for consumers is at least for the first half of 2016 mortgage rates should remain fairly stable. With the prospect of economic unrest at home and abroad more likely this year than last, there is a more than fair chance mortgage rates will remain about where they ended last year. If that turns out to be true, then fixed-rate 30-year mortgages should stay in a range between 3.9% and 4.2%.
