Federal Reserve policy and mortgage rate cycles
We've come to the end of the Fed's Quantitative Easing program, a process intended to keep long term interest rates low though the purchase of Treasury Bonds and to keep mortgage credit flowing at low rates though the purchase of agency-issued Mortgage-Backed Securities (MBS).
Now that this process is complete, the Fed may continue to "recycle" money into Treasuries and MBS. As cash comes in from bonds and mortgages that have been paid off or refinanced, there will likely be Fed influence in the market for some time to come even after the Fed has stopped accumulating debt and bloating its balance sheet.
We also may have a lull for a while before the Fed begins to lift the short-term interest rates it uses to manipulate the economy. Traditionally, these include the federal funds and discount rates, but there may be new tools the Fed will use to jack up interest rates, too. These include paying banks to keep funds parked with the Fed (called "Interest On Excess Reserves") or though a different, more complex method of swapping Fed-held debt for bank cash holdings (called a "Reverse Repo" agreement).
Volume, duration and velocity
Regardless of the tools the Fed uses to get there, interest rates will be elevated over time. The questions are, then, "How much will the Fed lift short-term rates?" (aka "volume"), "How long will it take them to get to their likely peaks?" (aka "duration"), and "How fast will they move them there?" (aka "velocity"). Obviously, for homebuyers, the final question is, "Where will mortgage rates be when higher short-term rates are in place?"
It bears noting that the Fed will begin its next campaign in a very unusual position, since nominal interest rates hover near zero. It also should be noted that the economy seems to be particularly sensitive to interest-rate changes in this cycle, so there is a risk for unintended economic damage if the Fed moves too fast or too far. Homeowners, homebuyers and those in the mortgage market remember well the effects on the housing and refinance markets in mid-2013, when a spike in mortgage rates happened in the aftermath of then-Fed Chairman Bernanke's comments that suggested QE would eventually come to a conclusion. Starting in May 2013, average 30-year fixed rates rose by more than a full percentage point over a 10-week period.
Changes to the downside
It's fair enough to say that history is likely to be a lousy guide to the future, but it's all we have to go on to make judgments. Since the 1980s, there have been 10 fed cycles for rates, both up and down. There have been periods of pretty pronounced increases, but decreases have been generally larger; for example, a downdraft from 1989-1992 saw a full 6.75 percent chopped off of the Federal funds rate as it shrank from 9.75 percent to 3 percent. Other declines of similar size include a 5.875 percent cut from 1983-1986, and more recently, a 5.5 percent slide from 2000-2003. The most recent episode of 2006-2008 was a sizable 5.125 one as well, and left us at today's historically low levels.
Changes to the upside
So much for the downside of rates. Given that interest rates have generally been declining for 30-plus years since the inflation-fueled rates of the early 1980s, the Fed has arguably had some leeway in raising rates, since many of yesterday's "lows" were still elevated by historical standards. The Fed has exercised somewhat more caution in raising rates when needed, with the largest increase occurring from 2003 lows to 2006 highs, a cumulative increase of 4.75 percent in the Funds Rate. Other smaller cyclical increases of 3.875 percent (1986-1989), 3.25 percent (1982-1983) and a flat 3 percent in 1992-1993 have been seen. The smallest of the increase bunch was just 1.75 percent from a 1998 low to a year 2000 peak for the very short cycle.
Average or typical "volume"
For the last 10 Fed cycles of rates (both up and down) the average cumulative move is 4.125 percent. From the near-zero level where we'll begin the process when the Fed does begin to increase short-term interest rates, history suggests, when the cycle of raising rates is completed, that this process would leave us with a Federal funds rate of about 4.25 percent, all things considered. However, as noted above, the Fed has at times expressed more caution in raising rates than lowering them, or at least limited how far they have gone. In this way, the average upward move for the Fed over the last 10 cycles has been about 3.25 percent, which would leave us with a Funds rate of about 3.375 percent. As we're starting from such a low point, and with it likely that the Fed will want some space to lower rates when the next downcycle begins, we're probably going to see an upcycle for the Fed Funds rate of perhaps 3.875 percent -- landing us at a nice round 4 percent for the Fed's key policy tool.
Average or typical "duration"
How long will it take the Fed to get us back to that level? Again, history's not likely to be much of a guide, since the Fed will be responding to changes in inflation and economic growth as they come along. Still, it's useful to remember that the Fed has stated it expects to begin to change policy at some point in mid-2015, and absent emergencies, makes policy changes only at its regular FOMC meetings, usually every six weeks or so. If the Fed was to begin raising rates at its June 16/17 2015 meeting, and did so at a regular pace of a quarter-point move in the federal funds target rate at that point, we would see the Fed funds rate approach 4 percent in March or April of 2017.
If the economy is not keeping pace as the Fed raises rates, the process may certainly take longer. A similar pace of increases between 2003 and 2006 most certainly did cool the economy, and the rise in short-term rates (and the effects of Fed policy on funding costs in global markets) may have precipitated the early days of the subprime ARM crisis, when rates were being adjusted sharply upward, causing payment shock for borrowers. That said, a 4 percent Federal funds rate is considered to be pretty close to "normal", and is historically pretty close to average, so the Fed will probably want to get there.
Average or typical “velocity”
The most recent iterations of the Federal Reserve policy-setting committees have all shown a preference for small changes in the Federal funds rate, usually a quarter-percentage point at a time, with a few half-point (or more) exceptions, most often on the downside. Could they move more quickly? Sure. If inflation seems to be getting a toehold or the economy begins to run at a fast pace, more sizable moves of perhaps a half percentage point at a clip are a possibility; also, some Fed governors may prefer moving more quickly away from rock-bottoms rather than see the markets endure a slow-drip of monetary policy changing over a range of years.
What will happen to mortgage rates?
Is the history of fairly recent Fed moves any help here at all? Well, the environment in which mortgages are priced today is certainly different than in the past, so the experience taken from those episodes may not be all that helpful. However, the last time we had a federal funds rate at about 4 percent, either precisely at this rate (or rising or falling though it) was in late 2007, and prior to that, November 2005, May 2001 and spring 1994.
The most recent period is arguably most relevant. In late 2007 and early 2008, 30-year fixed mortgage rates slid just below the 6 percent mark, but it is reasonable to say that credit conditions were deteriorating quickly at that point and few folks wanted anything to do with buying mortgages, so that may have kept rates more elevated than they otherwise might have been.
Still, there was no shunning of mortgages of any means back in 2005, and even though the funds rate was moving in a downward fashion, conforming 30-year fixed rates remained around the 6.25 percent mark, so it may be that this is a "true" or "natural" level for mortgages when the Funds rate is around the 4 percent mark.
Earlier periods are less relevant and certainly provide less comfort. Back in 2001, a 4 percent funds rate was paired with 30-year fixed mortgage rates hanging around 7 percent... and back in 1994, mid-to-upper 8 percent mortgage rates were in play.
Interest-rate relief may be hard to find
When fixed mortgage rates eventually do rise, there will continue to be other options for borrowers; that said, it may be that borrowers will have to make difficult choices when trying to choose a mortgage. Common Adjustable Rate Mortgages (ARMs) will of course be available in the market, and these may provide a lower-cost option for at least some period of time, while holding out the possibility to borrowers for lower rates in the future. Those looking for considerable interest rate relief will probably be disappointed, though, at least if recent comparisons of the last few times we saw 6 percent 30-year fixed rates holds true.
For example, in early 2008, rates for both 30-year fixed and initial rates for 5/1 ARMs were both just under 6 percent. At the time, investors and lenders were generally shunning mortgages, so there was no aggressive pricing by lenders to provide much by way of discounts on ARMs to mortgage shoppers. Rather than shunning them, investors and lenders were aggressively marketing mortgages of all stripes back in late 2005 and early 2006, a prior episode of 30-year fixed rates climbing above the 6 percent mark. At that time, the interest rate break for selecting a 5/1 ARM was just a third of a percentage point or less, so there was no relief to be found.
With this the case at the time, it's little wonder that borrowers looking to afford homes with fast-rising home prices felt compelled to consider at the lower monthly payments available on interest-only and Option ARMs to enhance affordability.
Puny spreads between the 30-year fixed rate mortgage (FRM) and 5/1 ARM products have existed at other times, too, so borrowers should not expect to always find the one-percentage point (or more) break we commonly see today. In fact, the average break over the last 20 years is a little more than two-thirds of a percentage point (just 0.67 percent).
Wrapping it all up
So, looking forward to the next few years of changing Fed policy, it may take a while to get us back to "normal" for the Federal funds rate. To be fair, 5 and 6 percent fixed-rate mortgages are still historically quite good, but will feel expensive relative to the bottoms and near-bottoms for rates we've become accustomed to during the extraordinary times of the crisis and post-"Great Recession" era. Regardless of whatever nominal level they ultimately achieve, if mortgage rates are perceived as "high" we may see the more of the kind of unintended economic damage to housing we noted early on in this article.
All in all, if you're thinking of buying a home in 2017 or thereabouts, it might be a good idea to use a mid-5 percent interest rate for 30-year fixed rates in your calculations. Between now and then, we'll probably have a gradual uptrend for mortgage rates on our way to an eventual peak, more likely in fits and starts than not.
If you plan on selling a home on our way to (or at) the next peak of mortgage rates, know that rising interest rates mean affordability for buyers gets crimped, especially if there are no lower-cost substitute products for buyers to turn to when loan costs go up. As such, you may not have as much pricing power as you do now, or at other times when mortgage rates are lower.
A 25-year expert observer of the mortgage and consumer debt markets, Keith Gumbinger has been cited in thousands of articles covering a wide range of consumer finance and economic topics in outlets ranging from the Wall Street Journal to the Bottom Line newsletters. He has been a featured guest on national broadcasts for CNN, CNBC, ABC, CBS and NBC television networks and has been heard on NPR and other national and local radio programs. Keith is the primary researcher and writer for HSH.com's MarketTrends newsletter and has authored or co-authored a number of consumer guides on mortgages, home equity, refinancing and more.
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