The Fed Cut. Why Did Home Mortgage Rates Rise?
On Tuesday, September 17th, the average nationwide 30-year fixed mortgage rate per Mortgage News Daily was 6.11%. The next day, as expected, the Federal Reserve made its first interest rate cut in nearly four-and-a-half years. The only surprise at the time was the magnitude of the cut, as the Fed reduced rates by 50 basis points (i.e. 0.50%) rather than 25 (i.e. 0.25%).
What has been surprising to many observers (and borrowers) since, however, is that contrary to some expectations, home mortgage rates have actually gone up since mid-September. The chart below shows the current 30-year rate hovering just over 6.6% to close the week, almost exactly 50 basis points above where it was prior to the Fed’s September cut. What the heck?
What the Fed Can and Cannot Do
The first thing to understand about this odd situation is that the Fed does not actually dictate mortgage rates. Those are based on a broad range of factors that we’ll dig into below. Yes, the Fed’s rate cuts are meant to encourage borrowing and keep the economy moving, but other factors are at play too, which over the past three weeks have been pushing mortgage rates in the opposite direction of what might have been intuitively expected.
The Fed also primarily influences short-term rates, including rates that banks can borrow from each other to fund loans or to increase their capital. A 30-year mortgage, on the other hand, has a term that is just that: 30 years. The variables are different over a 30-year time horizon than over the short-term.
Banks price loans based on their own risk tolerance combined with their expectations of the future economy including inflation. But beyond that, there is an additional and less intuitive (but arguably more important) variable that goes into how banks price home mortgages, and that is what they can package them for on the secondary market.
People like the idea of their local bank booking and holding their home mortgage until the day it is ultimately paid off. This does still happen, especially with smaller community banks and credit unions. But even the smaller banks (and, of course, the big bank lenders and mortgage companies) package the loans they book into mortgage-backed securities (MBS’s) that are made available on the secondary market to investors, pension funds, and others. Investors will buy groups of MBS’s (sometimes made up of millions of separate tiny slices), because they are a portfolio diversifier and offer what is hopefully a steady and safe yield, but one that is above what can be earned through a traditional government bond or U.S. Treasury note. Oftentimes the bank that booked the original loan remains the servicer and customer-facing representative on that loan, but the actual home loan has been sold to a secondary party for packaging into a MBS.
MBS yields are commonly about 150 basis points (i.e. 1.5%) above the 10-year Treasury Note. For example, if investors can get 4.0% on a 10-year Treasury Note, the yield on a MBS will be around 5.5%. This spread exists because MBS’s are riskier than government bonds, so investors demand a premium in order to invest in them. This spread can vary, however, based on market conditions. In periods of uncertainty, the MBS yield may be greater than 1.5%. And this is among the reasons why home mortgage interest rates have gone up in the past month: because there is uncertainty out there about the future of the economy and inflation. As such, MBS investors are demanding a greater premium to U.S. Treasuries as an investment, and in order to package their home loans to the secondary market, banks have had to increase the rate on their home mortgage within the last month to account for that.
One Additional Variable: Lender Caution and Tight Housing Supply
The role of lenders and the calculations of banks should not be ignored in this either. Even if market conditions were perfect for lower mortgage rates, lenders might still be cautious. Banks and mortgage companies are well aware of the risk environment right now, and many are reluctant to lower rates aggressively when they are unsure how things will shake out with the economy. On top of that, the tight housing supply in many markets gives lenders less incentive to slash rates. If demand for homes is outpacing supply, lenders don’t need to offer lower rates to attract borrowers.
Final Thoughts
It’s easy to get frustrated when the headlines make it sound like borrowing should be getting cheaper, but the reality is more complex. In fact, we might be in for a period where mortgage rates remain stubbornly high, even as the Fed continues to lower its target interest rate. Inflation concerns, bond market dynamics, and lender caution are all creating headwinds in the housing market.
So, what is a borrower to do? If you’re in the market for a home, it’s worth keeping an eye on the broader economic indicators rather than just the Fed’s moves. Watch for signals that inflation is truly under control, and keep tabs on how the bond market is reacting to each new piece of economic data. If bond rates come down (particularly the 10-year U.S. Treasury), home mortgage rates are likely to drop too.
Addendum: What About Commercial Rates?
A brief final thought on the topic of interest rate moves: commercial rates have, in fact, been edging downward over the past month. The main reason why the trajectory of commercial and residential rates have diverged is mostly that banks typically do not sell their commercial loans to a secondary market as commonly as they do with home loans. Banks can price their commercial loans in-house based on their own profit margins and motivations without needing to be concerned about investor demands out there as with the MBS market. Banks have their own competitive pressures when pricing commercial loans, but that is commonly due to dynamics with their own balance sheets and in the general competition to attract loan activity, and not due to some kind of secondary market.
Lastly, banks commonly price commercial loans at a margin above their Federal Reserve interest rate of choice, like the Prime Rate. When Prime Rate goes down by 0.50%, for example, bank loans that are priced at a margin of, say, 1.00% above Prime Rate go down correlatively. Prime Rate most recently was 8.50% but was dropped to 8.00% by the Fed in September. Accordingly, a lot of commercial interest rates also dropped by about the same margin (although not everywhere and for all types of loan; talk to your Lender for more color on this).
Ben Sprague lives and works in Bangor, Maine as a Senior V.P./Commercial Lending Officer for Damariscotta-based First National Bank. He previously worked as an investment advisor and graduated from Harvard University in 2006. Ben can be reached at ben.sprague@thefirst.com or bsprague1@gmail.com.
Weekly Round-Up
Here are a few things that caught my eye this week:
In Boston, property taxes are skyrocketing due to a decline in commercial office building values. In other words, as office buildings have declined in value, they have paid less in property taxes. In order to meet the demands and needs of the city budget, residential property taxes have had to go up to make up the difference. Some property taxpayers are facing an increase of as much as 28%! Read more here. This is a dynamic at play all over the country.
Despite the fears out there, the stock market continues to roll along. The S&P 500 and Dow Jones both closed on Friday at all-time highs. This is the quietest bull market I can recall. Read more here.
Arian Campo-Flores had an interesting piece in the Wall Street Journal about how many people came to Florida seeking paradise, but are now leaving after relentless storms, rising insurance costs, and other factors. Read it here. My thoughts are with all of those suffering in the aftermath of both Hurricane Helene and Hurricane Milton.
Have a great week, everybody!