Real Estate

The mortgage market isn’t sending the signal homebuyers need on affordability

A new housing development built along a canal near the Mokelumne River is viewed on May 22, 2023, near Stockton, California.
George Rose | Getty Images

Lawrence Yun has as big a stake in the Federal Reserve’s moves as any economist: As the chief economist for the National Association of Realtors, his industry is a target of the Federal Reserve’s efforts to tame inflation with higher interest rates.

But the housing’s industry’s bigger problem right now may be the bond market, and specifically, spreads between treasuries and mortgage rates that suggests homebuyers’ economic challenges may not decline even as the Federal Reserve is nearing the end of its interest-rate hikes. There is a historically-wide difference between the 10-year treasury bond, a benchmark for pricing mortgages, and the actual price of an average 30-year loan. Usually around 1.75 percentage points, and as low as 1.3 in 2021, the so-called mortgage spread is hovering at more than 3 percentage points now. And that is propping up mortgage rates, keeping home owners from selling their homes and buying nicer ones, and hurting first-time buyers, Yun said.

“Buyers know 3.5% mortgages aren’t coming back,” Yun said. “So 5.5% would bring out buyers.” 

Why mortgage spreads should move lower

Logically, mortgage spreads should move down sharply from here, thanks to the recent spate of good economic news, and bring relief to home buyers who have seen affordability deteriorate sharply since 2020. 

Traditionally, spreads widen when markets fear a recession. They spiked before the financial crisis of 2008, for example. Collapsing spreads help revive housing activity after a recession arrives, or can prop up the housing market in a crisis, which happened in 2021 as the Covid pandemic threatened an economic crash. But as the Fed began raising interest rates in March 2022, mortgage rates rose even faster than bond yields.

The case for wide spreads this past year was two-fold. Partly, it was rooted in the idea that the 10-year treasury yield would rise as the Fed hiked more. Fear of a 2023 recession also contributed — evidenced by a sharp widening of spreads in March, after Silicon Valley Bank failed.

Now, both cases are evaporating. Last week’s inflation report showed consumer prices rose just less than 3% for the 12 months ending in June, down from more than 9% a year earlier. Low inflation should persist into the fall, because the government’s measure of housing inflation lags private market data that has been moving lower since last summer. The consumer price index is expected to only start to reflect the now year-old dip in rents and home prices in parts of the U.S. by year-end.

At the same time, the Atlanta Federal Reserve Bank’s tracking estimate of second-quarter economic growth now sits at 2.3% belying predictions of an early-2023 recession that were widespread.

The recent inflation news pushed the 10-year treasury lower, touching 3.76% after reaching 4.09% earlier in July. Mortgage rates also dropped, to 6.89% last Friday from a recent peak of 7.22%, according to Mortgage News Daily. But the spread between the two was little changed.

How much the big mortgage spread costs homeowners

If the spread between 10-year bonds and mortgages were to revert to normal, it would make a huge difference in monthly payments for home buyers.

On a $500,000 mortgage, for example, a 7% interest rate spits out a monthly payment of $3,327, plus taxes and insurance. That falls to $2,934 if rates go to 5.8%, which would represent a 2 percentage-point gap between treasuries and mortgage rates, and to $2,777 with mortgages at a spread of 1.5 percentage points — back within the range of the long-term average, 1.75 points. 

The closing of spreads alone would save that borrower $6,600 a year in payments. A $500,000 loan would typically require about $150,000 in pretax annual income.

“People consider changing their cable company for $30 a month,” Yun said. “$600 a month is a big number.”

A narrowing of spreads last fall, which reversed in February and March, helped stabilize a falling real estate market, according to Logan Mohtashami, lead analyst for HousingWire in Irvine, Calif.

But bond market and housing experts are skeptical of whether the spreads will narrow, and mortgage rates fall, as fast as homebuyers might like.

The Fed is widely expected to raise the Fed funds rate at its meeting on July 25-26, with futures prices implying a 96.1% chance of a quarter-point increase, according to the CME Group Fedwatch Tool. That will support Treasury yields, at least in theory.

More than that, the Fed has stopped buying up mortgage securities as the bonds on its balance sheet mature. That depresses the price mortgages can command in secondary markets or from federally-backed loan buyers like Fannie Mae and Freddie Mac, and puts pressure on lenders to demand wider spreads from borrowers, said Rob Haworth, senior investment strategy director at U.S. Bank in Seattle.

Banks may also seek bigger spreads on loans made in the next few months because of the risk the mortgages will be repaid quickly when borrowers refinance next year as rates fall, he added.

“One might attribute it to quantitative tightening,” Haworth said. “The Fed is a seller.”

Indeed, the Fed has signaled that it doesn’t want mortgage rates to fall soon, according to Mohtashami, citing comments made by Minneapolis Federal Reserve Bank president Neel Kashkari who said in February that lower rates and a hotter market would “make our job harder” in controlling inflation.

“I assumed the spreads would stay high until the Fed cried Uncle and started cutting rates,” Mohtashami said. “If the banking crisis hadn’t happened in March, they would be lower.”

But markets have defied the Fed before, as recently as this week, when the 10-year Treasury yield dropped even as traders remain convinced the central bank will hike rates at least once more.

If the drop in inflation is sustained — a big if — and rising consumer confidence pushes any recession further into the future, markets are likely to reset interest rates with or without the central bank.

The Fed will raise rates at least once more, but the second rate increase many investors have expected may be delayed or canceled if inflation stays tame, said Doug Duncan, chief economist at Fannie Mae. That would let last week’s modest dip in mortgage rates continue, even though Fannie doesn’t expect the central bank to cut interest rates until at least early next year, he said.

How banks think about lending rates

Fannie Mae’s forecast calls for rates to be near current levels through 2023. But the Mortgage Bankers Association of America sees the 30-year rate dipping to 5.2 percent next year.

Banks’ reaction to changing spreads may be tricky to predict, Duncan said. On the one hand, banks would have to watch out for more prepayments if interest rates come back down, pressuring them to keep spreads wide, he said. But that might be overwhelmed by an increase in the value of mortgages that banks already own, as loans from the late 2010s and 2020 that pay lower rates regain value they lost as rates rose, he said. In that case, more banks would probably be more willing to let spreads fall, he added.

Mortgage rates could come down quicker than expected if banks respond to rising mortgage-bond values by relaxing spreads, Duncan said. When the Fed tried to talk markets into tightening credit in 2013, mortgage spreads actually became smaller, loosening mortgage credit, Haworth said. 

“Unless rates go back to 3 percent, banks are still going to be better off, even if prepayments pick up,” Duncan said.

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