Insufficient Affordability Signals in the Mortgage Market for Homebuyers

Lawrence Yun, the chief economist for the National Association of Realtors, is closely monitoring the actions of the Federal Reserve, as it directly impacts the real estate industry. While the Federal Reserve aims to control inflation through increased interest rates, the housing industry faces another challenge: the bond market and the growing disparity between treasuries and mortgage rates. This widening spread indicates ongoing economic difficulties for homebuyers, even as the Federal Reserve nears the end of interest-rate hikes.

Typically, the mortgage spread, which measures the difference between the 10-year treasury bond and the average 30-year loan, hovers around 1.75 percentage points. However, it has now surpassed 3 percentage points. Consequently, mortgage rates remain high, discouraging current homeowners from selling their properties and preventing first-time buyers from entering the market. According to Yun, this situation further underscores the fact that mortgage rates as low as 3.5% are unlikely to return, and a reduction to 5.5% would generate more interest from buyers.

One would logically expect mortgage spreads to decrease significantly, given recent positive economic indicators. This would bring relief to prospective homeowners who have witnessed affordability decline significantly since 2020.

Traditionally, spreads widen when there is a fear of recession in the markets. This was evident before the financial crisis of 2008. Conversely, falling spreads help revive housing activity during an economic downturn or can stabilize the housing market during a crisis. In 2021, amid the threat of an economic collapse due to the Covid pandemic, spreads widened. However, as the Fed commenced its interest rate hikes in March 2022, mortgage rates rose at a faster rate than bond yields.

Over the past year, there were two main factors contributing to wide spreads. Firstly, it was anticipated that the 10-year treasury yield would rise as the Fed continued hiking rates. Secondly, fears of a 2023 recession contributed to this trend. This was evident in March when spreads drastically expanded following the failure of Silicon Valley Bank.

However, the rationale behind wide spreads is now dissipating. The latest inflation report revealed a year-on-year increase in consumer prices of just under 3% for the 12 months ending in June, down from over 9% the previous year. It is expected that low inflation will persist into autumn, as the government’s method of measuring housing inflation lags behind private market data, which has been showing a decline since last summer. The consumer price index is projected to reflect the dip in rents and home prices across certain areas of the U.S. by the end of the year.

The Atlanta Federal Reserve Bank’s second-quarter economic growth estimate now stands at 2.3%, contradicting previous predictions of an early-2023 recession. Recent inflation news caused a drop in the 10-year treasury, reaching 3.76% from its July peak of 4.09%. Mortgage rates also decreased, with Mortgage News Daily reporting a drop to 6.89% from a recent high of 7.22%. However, the spread between the two rates remained relatively stable.

If the gap between 10-year bonds and mortgage rates were to return to normal, it would significantly impact monthly payments for homebuyers. For a $500,000 mortgage, a 7% interest rate results in a monthly payment of $3,327, excluding taxes and insurance. With rates at 5.8%, representing a 2 percentage-point difference, the monthly payment decreases to $2,934. Further, if the mortgage rate spread is 1.5 percentage points, the payment falls to $2,777, aligning with the long-term average of 1.75 points.

Closing these spreads alone would save borrowers $6,600 annually. Typically, a $500,000 loan requires around $150,000 in pretax annual income. This magnitude of savings is comparable to the importance people place on changing their cable company for a $30 monthly difference.

Last fall, narrowing spreads helped stabilize a declining real estate market, but experts question whether spreads will narrow and mortgage rates will decrease as quickly as homebuyers desire.

The upcoming Fed meeting on July 25-26 is expected to result in a quarter-point increase in the Fed funds rate, according to the CME Group Fedwatch Tool. This, in theory, should support Treasury yields. Additionally, the Fed has ceased purchasing mortgage securities, impacting the prices they can command in secondary markets. Consequently, lenders may demand wider spreads from borrowers, especially due to the risk of quick loan repayments when borrowers refinance as rates fall next year.

Haworth noted that the current situation could be attributed to quantitative tightening. He stated, “The Fed is a seller.” Mohtashami supported this view, referring to the Fed’s indication that it does not want mortgage rates to decrease anytime soon. According to him, Minneapolis Federal Reserve Bank president Neel Kashkari echoed this sentiment in February by saying that lower rates and a more heated market would “make our job harder” in terms of controlling inflation. Furthermore, Mohtashami expressed his belief that the spreads would have remained high if not for the banking crisis in March.

However, markets have defied the Fed before, as evidenced by the recent drop in the 10-year Treasury yield despite expectations of rate hikes. Should inflation remain subdued, and with rising consumer confidence potentially delaying a recession, the market may independently reset interest rates regardless of the central bank’s actions.

Chief economist at Fannie Mae, Doug Duncan, predicts that the Fed will raise rates at least once more, but the anticipated second rate increase could be postponed or canceled if inflation remains under control. Fannie Mae expects interest rates to remain steady until early next year, which would allow for the continuation of the recent slight decline in mortgage rates.

While Fannie Mae’s forecast suggests rates will remain near current levels through 2023, the Mortgage Bankers Association of America sees a dip in the 30-year rate to 5.2 percent in the coming year.

Predicting the reaction of banks to changing spreads is challenging. On one hand, if interest rates decline, banks may face increased prepayments and be motivated to maintain wider spreads. On the other hand, the value of existing mortgages held by banks could increase as loans from the late 2010s and 2020, which carry lower rates, regain lost value from rising rates. In such a scenario, banks may be more inclined to allow spreads to shrink.

Chief economist Doug Duncan suggests that mortgage rates could decline faster than anticipated if banks respond to rising mortgage-bond values by loosening spreads. He pointed out that in 2013, when the Fed attempted to tighten credit, mortgage spreads actually narrowed, resulting in looser mortgage credit.

Duncan also highlighted that even if prepayments increase, banks would still benefit unless rates return to 3 percent.