Interest Rates & The Fed
After years of easy money policies, the Fed began raising the overnight rate in March of this year and has continued to increase it at unprecedented speed. This directly and immediately pushes up short-term consumer rates such as credit cards, auto loans, and HELOCs.
But not mortgage rates - at least not directly.
Most mortgages are sold on the bond markets, and mortgage rates are tied to trading in these markets. When investor demand for mortgage bonds (known as MBS) is high, rates are low, and vice versa. Guess who the biggest investor in MBS has been.
If you guessed the Fed, you're right. Through a policy called Quantitative Easing (QE), the Fed bought as much as 38% of the entire US mortgage market and now holds well over $2Trillion of mortgages on its books. All the income the Fed got from interest and payoffs was reinvested back into more mortgages. Party on!
Now the party is over. The Fed is into Quantitative Tightening (QT). As mortgages are paid down the Fed is allowing up to $35 billion a month to roll off its balance sheets (not reinvesting), effectively removing that money from the economy, reducing demand for new mortgage bonds, and pushing up interest rates.
Mortgage Rate Benchmark
As I said, mortgage rates are not directly set by the Fed’s control of the Federal Funds rate. The key benchmark for mortgage rates is the 10-year Treasury bond. This is primarily because most 30-year mortgages are paid off within 10 years.
The 10yr Treasury is a mortgage benchmark, not an index, meaning the two track very closely together but are not tied to each other. Mortgage rates generally move up and down along with the 10-year Treasury.
You can see from the chart that the two rates move in more or less the same way, with the mortgage rates tracking somewhat higher than the Treasury. The difference between the two is called the spread.
You can think of the spread as a margin; the amount lenders add to the Treasury yield to price mortgages. It’s simplistic, but true enough for our purposes. It is also a critical factor affecting mortgage rates.
The spread is not fixed. Lenders can’t control the market for mortgage bonds or treasuries, but like any business, they can control the margin they charge on their product. They expand or narrow the spread depending on demand, competition, and risk. This causes mortgage rates to go up or down relatively more or less than the 10-year Treasury.
Currently, the spread is widening, meaning mortgage rates are going up faster than treasury yields. In fact, the spread is currently at the highest it’s been since the mid-1980s. We’ve only had spreads
this high after the crash of 2008 and briefly during the initial panic of the Covid pandemic in 2020.
Why is the spread widening?
Lenders adjust their margins based on a variety of factors. Today, one of the main factors driving expanding margins is prepayment risk.
Lenders (called investors in the mortgage industry) make loans with the expectation that they will earn a certain amount of interest over a certain amount of time. If they don’t get the payments they expect, either because a borrower defaults or pays off/refinances the loan early, the lender doesn’t make as much profit or none at all.
With interest rates as high as they are today, if/when rates move down again anybody who has a loan at current rates will refinance it for a lower rate. Lenders are concerned, even expect, that new mortgages will be paid off faster than their profit models contemplate, so they are taking a wider margin upfront to compensate.