Falling mortgage rates: How low will they go?

Mortgage rates have fallen significantly in recent weeks.

The average 30-year fixed rate mortgage was 7.22% during the week of November 30, down from a peak of 7.79% at the end of October.

The rise in mortgage rates in the last couple of years has been challenging for anyone looking to buy a house. 

Could we be seeing the beginning of a change in that trend? And if so, how low might mortgage rates go? 

Here’s how we’re thinking about the mortgage market and where it might go next.

Mortgage rates are mostly set based on long-term bonds

To see if mortgage rates can keep declining, we first need to consider how mortgage rates are set in the first place. 

About 76% of US mortgages are packaged into bonds and sold to investors, mainly by Fannie Mae or Freddie Mac. Generally, you don’t know that your mortgage has been sold to investors. You keep sending your payments to your bank, but the bank passes those payments on to mortgage bondholders behind the scenes. Consequently, the main driver of the mortgage borrowing rate (the one banks offer) is the rate at which they can resell this mortgage in the bond market.

Since the US government backs Fannie Mae and Freddie Mac, bond investors consider these bonds extremely high quality. They essentially compete with Treasury bonds for investor dollars. The chart below shows that mortgage rates have closely tracked longer-term Treasury bond yields over time.

As a result, if we’re trying to determine if mortgage rates can keep falling, we really need to ask if Treasury bond yields will decline.

The Fed is likely to cut rates in 2024

One significant influence over Treasury bond yields and, therefore, mortgage rates is the Federal Reserve’s target rate. 

We know the major surge in bond yields in 2022 was driven by the Fed’s aggressive rate hikes. So, it stands to reason that bond yields will fall if the Fed reverses course and starts cutting in 2024.

We believe that the Fed is more likely than not to cut rates in 2024. In a recent talk given to the American Enterprise Institute, Fed Governor Christopher Waller said during the Q&A that if inflation were to continue declining over the next three to five months, “we could start lowering the policy rate just because inflation is lower.”

In context, Waller said the economy doesn’t have to be in trouble for the Fed to cut. In other words, as the inflation rate gets closer to the Fed’s target, the Fed doesn’t have to be as restrictive. Specifically, Waller cited the economic models the Fed uses to help them set policy. These models would suggest a lower rate when inflation is 3% vs. 5%. 

In real-time, the Fed can’t know the true underlying inflation trend because inflation can bounce around. But Waller is saying that if we see a few more months of better inflation numbers, his confidence that the trend is lower will grow.

You can see why Waller is starting to gain that confidence. The chart below shows the Fed’s favored inflation measure, Core PCE Inflation, on a 12-month and 3-month annualized basis.

We have been talking about inflation improving for a while, but now it is pretty undeniable. 

We should note that Waller is a very influential member of the Fed’s decision-making committee, but he is just one member. 

There is no guarantee that Chair Jerome Powell or others on the committee will agree with Waller. However, Powell did give a speech a few days later, which could have been an opportunity to refute Waller’s remarks, which he did not.

Between the better inflation figures and comments like Waller’s, the market is now anticipating a total of five Fed rate cuts in 2024, with the first coming sometime around March, based on pricing in the futures market.

But long-term bond yields already reflect future Fed cuts

The potential for Fed rate cuts is great news for those hoping mortgage rates fall. However, remember that mortgage rates mostly follow long-term Treasury rates, not the Fed directly. 

Long-term Treasury rates are a function of anticipated future Fed policy. In other words, the 10-year Treasury yield can be considered the market’s best guess at what the average Fed target rate will be over the next ten years.

Consequently, if the market is already anticipating five Fed rate cuts next year, that’s already priced into the 10-year Treasury yield. And if it is priced into the 10-year yield, it is mostly already priced into mortgage rates as well.

For Treasury rates to keep falling, the market will need to anticipate more Fed cuts than just the five already priced in. Now, those could come in 2024 or later years. However, don’t get caught in the trap of assuming that other kinds of interest rates will fall just because the Fed may be cutting. They might, but they might not.

There is room for compression between mortgages and Treasuries

That being said, some technical quirks in the mortgage market today give some hope for lower mortgage rates even if Treasury yields hold steady.

Historically, mortgage rates have always been somewhat higher than the 10-year Treasury, despite the fact that the US government backs mortgages. The main reason for this isn’t going to change: mortgages can be repaid at any time, which creates some uncertainty for investors. They, therefore, demand extra interest for taking on this uncertainty. 

Still, the gap between Treasuries and mortgages is unusually large, which is called a “spread” in bond lingo. The chart below shows this spread over the last thirty years.

On the chart, we see three big spikes in this spread. One was around the 2008 crisis. The next was around the onset of COVID. The third happened in 2022, and the spread remains elevated now. So the only other times this mortgage-Treasury spread has been this wide was during true crisis periods.

So why is the spread so elevated now? It is probably due to three big factors, all of which could subside in the coming quarters. The first two are related to banks, which tend to be large buyers of mortgage bonds. 

Banks have generally tried to reduce their holdings in long-term bonds ever since the collapse of Silicon Valley Bank earlier this year and, therefore, bought fewer mortgage bonds than they might have otherwise. However, as the SVB crisis fades, banks could start buying again, which would push mortgage rates down.

The second issue for banks is the inverted yield curve. When banks buy any kind of bond, they effectively use dollars gained from deposits. But because the curve is inverted, deposit rates are relatively high compared to the yield on longer-term bonds. 

We would anticipate the yield curve becoming less inverted, or even uninverted, as the Fed starts to cut rates. Already, the gap between the 2-year Treasury and the 10-year has gone from -1.09% earlier this year to just -0.36% at the end of November.

The last issue impacts all mortgage bond investors and is most likely to change. Mortgage bonds are very sensitive to interest rate volatility. This is because if interest rates rise by a lot, mortgage bonds lose money like every other kind of bond investor. 

If interest rates decline significantly, other kinds of bonds make profits, but mortgages primarily get refinanced. This means the mortgage investor has their principal repaid but doesn’t keep earning interest. Hence, mortgage investors don’t benefit much from falling rates.

Interest rate volatility has been extremely high lately. Interest rates have soared over the last two years, and investors logically assume they could also rapidly fall if conditions were to change. Indeed, the month of November saw the largest decline in the 10-year Treasury yields since 2008.

Given the fact that volatility has been so high, mortgage investors are demanding a lot of extra yield premium vs. Treasuries.

This premium could decline some in the coming months, though. If inflation were to keep subsiding, but the economy remains reasonably strong, the Fed will likely only make minor adjustment cuts in 2024. This could cause reduced interest rate volatility and result in a tighter spread on mortgage bonds.

Right now, the spread between the 10-year Treasury and the average 30-year mortgage rate is 2.89%. The long-term average is 1.77%. That means mortgage rates could decline by a full percentage point merely because the spread normalizes. We can’t guess at how quickly this might occur, but we are confident that mortgage spreads will not stay near these all-time highs forever.

Beware the effect mortgage rates could have on home prices

A couple of months ago, we wrote about the fact that pent-up demand for housing was keeping home prices high despite soaring mortgage rates. Demographics and a lack of home building over the last decade have created a very tight supply/demand dynamic, and this has kept home prices from declining.

Given these conditions, it is possible that any decline in mortgage rates unleashes some of this pent-up demand and pushes home prices higher. 

Remember that when you take out a standard home mortgage, you can refinance at any time. Yes, there are typically fees involved in doing so, but these fees are small compared to the price of a typical house. 

So, if you buy a house today and mortgage rates fall, you can refinance and get the benefit. If you wait and home prices rise, you might wind up no better off, even at lower mortgage rates.

Buying a home is a huge decision, with any number of factors you should consider. But given today’s situation, use caution if you’re just waiting for mortgage rates to fall. We think they will likely decline, but that doesn’t necessarily mean waiting will turn out to be a good financial decision.