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Mortgage rates may have some room to come down from 2023 peaks after dovish remarks from Federal Reserve policymakers Monday helped ease fears of more rate hikes and brought yields on a closely watched long-term bond down to where they were at the beginning of October.
Yields on 10-year Treasury notes, a barometer for mortgage rates, fell sharply Tuesday when markets reopened for the first time this week following Monday’s Columbus Day federal holiday (recognized by many states and cities as Indigenous Peoples Day).
10-year Treasury yield slides
Source: Yahoo Finance.
At one point Tuesday, yields on the benchmark bond touched a low of 4.62 percent, down nearly 30 basis points from Friday’s high of 4.89 percent. After easing at the end of August, yields on 10-year Treasurys have been climbing since September, reaching levels not seen since 2007 as incoming data showed economic growth and inflation cooling more slowly than many expected in the face of Fed rate hikes.
Mortgage rates have followed Treasury yields up in recent weeks to the highest level in more than two decades, and they’ve done so at a pace that’s far exceeded the Fed’s recent moves.
Long-term rates kept climbing after Fed pause
After approving 10 increases in the short-term federal funds rate between March 2022 and May 2023 totaling 5 percentage points, the Fed has implemented just one, 25-basis point increase in the second half of this year. But since the Fed’s last rate hike on July 27, long-term rates have continued to climb, with both 10-year Treasury yields and 30-year fixed rate mortgages gaining 80 basis points.
Speaking at the annual meeting of the National Association for Business Economics (NABE) Monday, Dallas Federal Reserve President Lorie Logan noted that some of the recent runup in long-term rates could be due to bond market investors’ expectations that the Fed will have to keep raising short term rates to get inflation under control, or at least keep short-term rates higher for longer.
But a good portion of the runup in long-term rates is probably driven by bond market investors demanding a larger “term premium” — they expect to earn a higher rate of return to compensate them for taking on the risk that interest rates may change over the life of the bond.
Logan said her “back-of-the-envelope” estimates suggest more than half of the total increase in long-term yields since the Fed’s last rate hike in July reflects rising term premiums. If that’s the case, bond market investors are essentially doing some of the Fed’s work for it, by demanding higher rates that are passed on to borrowers.
Lorie Logan
“Higher term premiums result in higher term interest rates for the same setting of the fed funds rate, all else equal,” Logan said. “Thus, if term premiums rise, they could do some of the work of cooling the economy for us, leaving less need for additional monetary policy tightening to achieve [Fed policymakers’] objectives.”
In other words, “If long-term interest rates remain elevated because of higher term premiums, there may be less need to raise the fed funds rate,” Logan added. “However, to the extent that strength in the economy is behind the increase in long-term interest rates, [Fed policymakers] may need to do more.”
Federal Reserve Vice Chair Philip Jefferson laid out similar views at the same event Monday, noting that higher interest rates not only have a chilling effect on spending by households and businesses, but affect risk premiums.
Like Logan, Jefferson said recent increases in real long-term Treasury yields could reflect not only investor fears of future rate hikes, but also changes in investor’s attitudes toward risk and uncertainty in general.
Philip Jefferson
“After increasing the target range for the federal funds rate by 525 basis points since early 2022, my view is that the [Federal Open Market Committee] is in a position to proceed carefully in assessing the extent of any additional policy firming that may be necessary,” Jefferson said. “We are in a sensitive period of risk management, where we have to balance the risk of not having tightened enough, against the risk of policy being too restrictive.”
But neither Logan or Jefferson are considered to be “doves” who are more worried about crashing the economy than inflation. Based on their past remarks, Reuters rates Logan as “hawkish” and Jefferson as “centrist.”
Their latest views are unlikely to appease real estate industry trade groups, who urged Fed policymakers Monday to promise that they’re not only done hiking rates, but have no plans to sell trillions of dollars of mortgage-backed securities (MBS) that the central bank bought during the pandemic.
An unusually wide spread between 10-year Treasury yields and 30-year mortgage rates reflects “deep-seated uncertainty about where the Fed is headed,” the Mortgage Bankers Association, National Association of Realtors and National Association of Home Builders warned in the letter.
Making “clear statements to the market” that the Fed won’t hike short-term rates or sell off any of its MBS holdings until the spread has normalized “will provide the market greater certainty about the Fed’s rate path and its plans for the MBS portfolio and reduce volatility for traders and investors,” the trade groups said.
Fed policymakers voted unanimously not to raise rates on Sept. 20, keeping the central bank’s target for the short-term federal funds rate at 5.25 to 5.5 percent. But most members of the Federal Open Market Committee have signaled that they expect to implement one more interest rate hike this year, which would would bring the short-term federal funds rate to 5.5 to 5.75 percent.
But futures markets tracked by the CME FedWatch Tool suggest investors now see only a 14 percent chance of another rate hike when the Fed meets next, on Nov. 1. Last week, futures markets were predicting a 28 percent chance of a Nov. 1 rate hike. The futures markets tracked by the CME FedWatch Tool still predict a 28 percent chance of one or more rate hikes by the time the Fed holds its last meeting of the year on Dec. 13.
Fed ‘quantitative tightening’
Source: Board of Governors of the Federal Reserve System, Federal Reserve Bank of St. Louis
Fed policymakers have another tool at their disposal to combat inflation: “Quantitative tightening,” launched last year to shrink the central bank’s holdings of Treasurys and mortgage-backed securities (MBS).
Logan noted Monday that Fed policymakers have made clear that they may continue to shrink the Fed’s balance sheet even after they’ve decided it’s time to bring the federal funds rate back down.
But rather than selling those assets, the Fed has been allowing up to $60 billion in maturing Treasurys and $35 billion in MBS simply run off the books each month without replacing them.
Even at that relatively modest pace of quantitative tightening, the Fed has shrunk its balance sheet by more than $1 trillion, with another $7.4 trillion to go.
Expectations that the Fed will continue to shrink its balance sheet “implies that other investors will need to hold more long-duration securities, which appears to be one factor among the many contributing to higher term premiums,” Logan said.
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