Editor’s note:
This is an update to the November 2023 analysis archived here.
Recently, mortgage rates have reversed some of their gains since 2020, falling from their recent peak in late 2023. In this article, we update our previous analysis and explore the factors that led to the rally through 2023 and the factors that led to a partial reversal. Overall, the increase in mortgage rates since 2020 reflects a significant increase in interest rates on long-term U.S. Treasury securities. However, the rise in 30-year fixed mortgage interest rates, especially from the beginning of 2022 to the second half of 2023, is abnormally large compared to long-term government bond interest rates, and it is possible that mortgage interest rates are being pushed up by more temporary factors. There is. The latest data shows that some of these temporary factors are beginning to dissipate. If these factors continue to ease and long-term government bond rates continue to fall, mortgage interest rates will likely fall further.
In the previous article, we investigated why mortgage interest rates through the second half of 2023 have risen significantly more than the yield on 10-year U.S. Treasury bonds. We found that about half of this spread increase can be attributed to two factors. First, interest rates on U.S. Treasuries with maturities of less than 10 years were higher than those on 10-year Treasuries, and second, the risk of prepayment on mortgage loans increased. The remainder of the increase in spreads can be attributed to other factors, such as reduced demand for mortgage-backed financial products.
Some of these factors that pushed up spreads have faded. Unlike at the end of 2023, interest rates on 10-year Treasuries are now higher than on 7-year Treasuries, and their duration is closer to that of a typical mortgage. Furthermore, the risk of prepayments also appears to have decreased because there has been some reduction in uncertainty surrounding future interest rates. The decline in these factors has been partially offset by factors that have pushed spreads higher in recent months. The idea is that the proliferation of premium lenders is charging borrowers more interest than lenders are effectively paying as their cost of funds. This premium may reflect increased demand for the lender’s services and pricing power due to the increased risk the lender faces of declining interest rates during underwriting.
Factors contributing to the spread between mortgage interest rates and 10-year government bond rates
Mortgage interest rates affect the price of real estate and housing equity because they reflect the cost of taking out a mortgage to purchase a home or access housing equity. Just as the Federal Reserve’s monetary tightening pushed up mortgage rates, this channel is an important way for monetary tightening to slow the economy and control inflation. As shown in Figure 1, mortgage rates (dark green) have been on a long-term downward trend over the past 40 years, consistent with the 10-year Treasury rate (light green). However, the spread between mortgage interest rates and government bond interest rates fluctuates for a variety of reasons, including changes in credit conditions and interest rate uncertainty.
Because both products are long-term and the risks of mortgages are relatively stable, mortgage rates are generally tied to the 10-year Treasury rate. Nevertheless, to compensate investors for the higher risk of mortgages, interest rates on fixed mortgages have historically averaged 1 to 2 percentage points higher than Treasury yields. Since mid-2020, as interest rates on 10-year U.S. Treasuries have risen, so have mortgage rates. As we discussed in a previous article, from early 2022 to 2023, mortgage rates rose by a surprisingly large amount relative to 10-year Treasury rates, further constraining borrowing terms and the housing market. But over the past year, the gap between the two rates has narrowed.
Figure 2 shows the spread between the 30-year fixed mortgage rate and the 10-year Treasury rate from January 1997 to September 2024. The peak spread during the housing crisis was 2.9 percentage points, reflecting the sharp tightening of credit conditions and significant turmoil in financial markets. A market that funds mortgage loans. Spreads rose again during the COVID-19 pandemic, peaking at 2.7 percentage points in 2020, due to short-term disruptions in financial markets and lender and investor concerns about mortgage assets. is reflected. From the end of 2022 to 2023, the spread between 30-year fixed mortgage rates and 10-year Treasury rates widened to unprecedented levels, hovering around levels last seen during the housing crisis. However, over the past year, spreads have started to decline, with September spreads lower than their peak levels during the pandemic, but still elevated relative to long-term trends.
To better understand the spread between the 30-year fixed mortgage rate and the 10-year Treasury rate, Figure 3 breaks it down into three components.
Blue: The spread between the interest rate charged to the borrower and the yield on mortgage-backed securities (MBS). It is called the primary-secondary spread. This spread is generally stable if mortgage origination costs are stable. Light green: combination of mortgage term and prepayment risk adjustment. The duration adjustment reflects the fact that mortgage tenures are generally less than 10 years and are more closely related to interest rates on seven-year Treasuries than on 10-year Treasuries. Prepayment risk reflects the likelihood that a borrower will exercise a refinance option due to future interest rate declines. Purple: remaining spread. Reflects changes in demand for mortgage-related assets after adjusting for prepayment risk.
Given estimates of 1 and 3, we can estimate 2 by subtraction.
Understand recent mortgage interest rates
Using this framework, we see that duration adjustment and prepayment risk are now less of a factor driving the spread between mortgage rates and the 10-year Treasury rate than they were in late 2023. Mortgages typically have a tenure of less than 10 years, so they have a shorter life than a 10-year Treasury bond. From early 2022 to 2023, the interest rate on the seven-year Treasury note exceeded the interest rate on the 10-year Treasury note for the first time since 2000. In recent months, this trend has reversed, with 10-year rates now higher than 7-year rates (in line with pre-pandemic trends).
Additionally, prepayment risk is slightly lower now than in late 2023 due to reduced interest rate uncertainty. If interest rates rise or fall, mortgage borrowers are affected differently. If interest rates rise, mortgage borrowers can simply choose to keep their mortgage at the previously issued rate. Instead, if interest rates fall, mortgage borrowers can refinance their mortgages at lower interest rates. In other words, if the range of uncertainty about future interest rates increases, even if the range is symmetrical, current mortgage borrowers are more likely to find it advantageous to refinance in the future. Coincidentally, measures of interest rate uncertainty (such as the MOVE index and the Merrill Lynch Option Volatility Estimator Index) are now lower than they were in late 2023.
Since the last analysis, the primary-secondary spread has increased, partially offsetting the effects of prepayment risk and duration adjustment. Lenders often finance mortgages by selling bonds to MBS, which are pools of mortgages guaranteed by government-backed companies. The spread between the primary mortgage rate for a borrower and the secondary MBS rate reflects the cost of issuing the mortgage and the cost that lenders with pricing power place on borrower demand. Both may be increasing. First, increased demand from mortgage borrowers has given lenders pricing power. Second, the originator must bear the interest rate risk from the time the mortgage interest rate is set until closing. In an environment where mortgage rates have fallen and are expected to continue falling, lenders face a significant risk that borrowers will renegotiate their loans at lower rates.
The final factor remaining after considering the above factors is option-adjusted spread (OAS, ‘Other’ in Figure 3), which has also been declining since late 2023. It is unclear exactly why this factor is small, but this pattern is seen across fixed income assets. For example, the spread between high-quality corporate bonds and 10-year U.S. Treasury rates has narrowed since the end of 2023.
conclusion
The Federal Reserve cut short-term interest rates by 0.5% on September 18, and further rate cuts are expected. If these trends (and others) continue to lower long-term government bond rates, mortgage rates are likely to continue to decline as well. Furthermore, if interest rate uncertainty decreases, the spread between mortgage rates and 10-year government bond rates should return to historical levels, and interest rates should fall further. These lower interest rates make borrowing cheaper for potential mortgage borrowers, such as those looking to borrow against their home equity or those looking to purchase a home. We believe that these lower mortgage rates alone are not enough to make housing widely affordable, and that we need to increase the supply of affordable housing for both homeowners and renters. Warn you.
