A sign in the window of a mortgage lender's office in Lake Oswego, Oregon, in 2020.
Anyone considering buying a home can attest that mortgage rates in the United States remain high. In June 2024, 30-year fixed-rate mortgage rates were around 6.9%. By comparison, in January 2019, just before the pandemic, they were around 3.6%. Will mortgage rates fall from their current high levels? While predicting the future is never certain, the chances that mortgage rates will fall are actually quite high.
Given recent monetary policy, it is reasonable to assume that inflation will eventually return to 2% per year, or at least close to 2%. Current Treasury bill interest rates are about 5.25% per year. With 2% inflation, a nominal Treasury bill rate of 5.25% means that real Treasury bill interest rates, or Treasury bill interest rates minus inflation, are historically very high. Not that long ago, real interest rates on Treasury bills were negative. Real interest rates on Treasury bills are temporarily high because the Federal Reserve has a policy goal of lowering inflation.
Inflation is significantly lower than it was two years ago. The Personal Consumption Expenditures Price Index increased 2.6% for the 12 months ending in May 2024. It increased 6.7% for the 12 months ending in May 2022. There are no signs of inflation picking up, and given the Fed's resolve so far, it is reasonable to assume that inflation will settle between 2% and 3% per year, if not 2%. Given that the historical average of real interest rates on short-term Treasury bills is near zero, short-term Treasury bill rates are likely to be around 3%.
Why do mortgage interest rates fall when short-term government bond interest rates fall? One reason is that yields on long-term government bonds fall. Long-term government bond interest rates reflect expectations of future short-term interest rates, and if expectations of future short-term interest rates fall, long-term government bond interest rates fall too. Falling long-term government bond interest rates also fall in long-term mortgage interest rates, but that's not all.
Figure 1 shows the 30-year mortgage rate and the 10-year Treasury yield separately. Figure 2 shows the spread, or difference, between the two. The 10-year Treasury yield is often used to compare with mortgage rates because the actual term of a mortgage is shorter than 30 years and the 10-year Treasury bond trades more frequently than the 30-year bond, making its price and yield more useful.
Both 30-year mortgage rates and 10-year Treasury yields have increased since 2020, but the increase in spreads has been more pronounced. Since Treasury bonds are risk-free in that they pay the promised amount, the spreads can be interpreted as risk spreads (they are nominally risk-free, but not in practice). Why have risk spreads increased?
The risk that lenders face is the risk of mortgage prepayments. Mortgage prepayments are a risk, usually when a borrower intentionally refinances their mortgage to obtain a lower interest rate. A lower interest rate for the borrower also translates to a lower interest rate for the lender if the lender replaces the refinanced mortgage with another mortgage.
Prepayment risk is the biggest risk for lenders. When interest rates are temporarily high, as they are now, the prepayment risk of a new mortgage is high. This is because interest rates are likely to fall in the future, making it advantageous for borrowers to refinance at the lower interest rate. In effect, the expected term of the mortgage is shortened.
Another commonly mentioned risk, foreclosure due to a recession, isn't actually a risk to lenders. The vast majority of mortgages in the United States are guaranteed by federal agencies commonly known as Fannie Mae, Freddie Mac, or Ginnie Mae. If a borrower defaults on their loan, the federal agency that guarantees the mortgage pays the mortgage and absorbs any losses after the home is foreclosed and sold. This means that default risk is not an issue for lenders.
However, foreclosure creates a risk that is different from default risk or loss. Foreclosure on a federally insured mortgage leads to prepayment. Default is still a risk, but it is a risk of prepayment rather than a risk of loss. Even if a foreclosure is not due to relatively high interest rates, a lender always runs the risk that the interest rate on another mortgage it obtains to replace the foreclosed mortgage will be lower.
The risk with mortgages goes beyond prepayments. The Federal Reserve acquired very large portfolios of mortgages as part of its quantitative easing program. The mortgages are packaged into securities called mortgage-backed securities (MBS) that can be traded after the mortgages are issued. For a time, the Federal Reserve acquired an amount of MBS equal to the amount of new mortgage issuance. The rationale for these purchases was to lower mortgage interest rates. Although not definitive, statistical evidence suggests that these purchases did in fact lower mortgage interest rates.
The Fed is currently selling mortgage-backed securities as it winds down its quantitative easing program, which has contributed to higher mortgage rates and a wider spread between mortgage rates and Treasury yields.
As long-term Treasury rates and spreads fall in the near future, mortgage rates will fall as well. If the Fed continues its current policy of decreasing inflation, a low inflation environment will lead to lower short-term Treasury rates. Lower short-term rates will lead to lower long-term rates, because long-term rates reflect the expectation of lower short-term rates. Lower interest rates will lead to prepayments, but the risk of future prepayments will decrease, and the spread between mortgage and Treasury rates will decrease. Furthermore, the Fed will eventually stop selling MBS, which will also decrease the spread. In other words, mortgage rates will fall due to lower inflation and lower risk-free rates, reduced prepayment risk, and reduced Fed sales of MBS.
Gerald P. Dwyer
Gerald P. Dwyer is a professor at Clemson University and a BB&T Research Fellow. From 1997 to 2012, he served as director of the Center for Financial Innovation and Stability and as a vice president of the Federal Reserve Bank of Atlanta. Dwyer's research has appeared in leading economics and finance journals, as well as publications by the Federal Reserve Bank of Atlanta and the Federal Reserve Bank of St. Louis. He serves on the editorial boards of the Journal of Financial Stability, Economic Inquiry, and Finance Research Letters. He is a past president and a member of the executive committee of the Association of Private Enterprise Education. He is also a founding member of the Society for Nonlinear Dynamics and Econometrics, having served as president and treasurer of that organization.
Mr. Dwyer earned his PhD in Economics from the University of Chicago, his Master's in Economics from the University of Tennessee, and his BBA in Business, Politics and Sociology from the University of Washington.
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