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Thinking about buying a home this spring? Check out the latest update to the income needed to buy a median-priced home in the top 50 metro areas.

Thinking about buying a home this spring? Check out the latest update to the income needed to buy a median-priced home in the top 50 metro areas.

February 2, 2024

Preface
The latest Fed meeting just passed, with no change to interest rates and no specific promise that the Fed will be cutting rates very soon (see our analysis of latest the Fed meeting).

At least as we write this, financial markets appear to have taken the Fed's updated stance to mean that restrictive monetary policy will be in place for longer, damping economic growth and pressing inflation even lower, at least in the short term. Mr. Powell's comments after the meeting diminished prospects for a cut in rates in March, as the FOMC wants to see more confirmation that inflation is moving sustainably toward their 2% core PCE target.

Although there's a lot of anticipation and speculation about how and when the Fed will change policy this year, it's worth remembering that long-term mortgage rates have already retreated significantly from their 22-year highs of last October. While still not exactly low, mortgage rates are roughly comparable to where they were a year ago at this time, when there were still three increases in the federal funds rate yet to come. With the economy fairly cruising along, labor markets solid and inflation still above the Fed's goal, the question is whether or not mortgage rates can retreat much from present levels, at least over the next forecast period.

The Fed last raised rates back in July 2023 and essentially promised more to come. At that time, the central bank began jawboning investors that rates would remain higher for an extended period of time without providing much by way of specifics as to how long that might be. While not directly comparable, the last rate-hiking cycle in 2018 saw the federal funds rate held at a peak level for a little more than seven months before the first decrease in rates came. The prior such episode through 2006 -- when the funds rate was roughly at current levels -- saw the key monetary policy rate hold there for about 15 months before the first cut (a 50 bp trim) came along. Presently, we've just passed the six-month mark of peak monetary policy rates.

Even if the Fed does begin to trim rates soon, and even if it does so regularly going forward, we already have a recent prime example in place showing how the federal funds rate has little direct influence on what happens to long-term mortgage rates. The federal funds rate was unchanged after July 26, 2023; however, mortgage rates moved up by a full percentage point though November. Since then, mortgage rates declined by as much as 1.19% from peak even as the federal funds rate has been held steady. Should the Fed cut a full percentage point off of federal funds over the course of this year -- a plausible amount -- the effective federal funds rate would still be 4.5%, or only as low as it was in December of 2022. At that time, mortgage rates were in the low- to mid-six percent range, not all that far from where they are today.

Fed or no Fed, mortgage rates probably have a limited downside for a while yet, at least until some of the more technical factors in the market find some kind of normalcy.

HSH.com 30-yr FRM Forecast Recap Graph

Recap
When we last looked forward back in December, we thought that the then-month-long rally for rates had run its course and was due for a partial retracement. That simply didn't happen, as there was still some rally momentum that lasted right though the end of the quarter and year, and mortgage rates declined rather below our expected range. Since then, mortgage rates have been essentially flat. Regardless, we missed the mark on this one; we expected that the average offered rate for a conforming 30-year FRM as reported by Freddie Mac would run a 7.02% to 7,47% range, but 6.60% to 7.22% was seen over the period. As far as hybrid ARMs go, the 6.52% to 6.94% bookends we forecast for the 5/1 ARM would have worked better for the 30-year FRM, as the markets produced a 6.14% - 6.58% pair, with a one-week holiday outlier coming in at 5.71%, probably due to thin applications for mortgages for the Christmas-New Year's week.

Interestingly, our September 29-November 30 forecast undershot the actual level of rates, while the December 1-January 26 overshot it. Perhaps our crystal ball was reversed or upside down or something. Suffice it to say we got caught leaning the wrong way.

HSH.com 5/1 ARM Forecast Recap Graph

Forecast Discussion
So the Fed has literally made no changes to monetary policy since last July in terms of rates, and its balance-sheet runoff continues at its prescribed pace. Why then would mortgage rates decline? Obviously, declining inflation has something to do with it, as does the line of thinking that the Fed will be lowering short-term rates at some point.

That said, part of the decline in mortgage rates since recent peaks has come from the more "technical" side of the equation. After the issues with Silicon Valley Bank, Signature Bank and others last year, many banks were not only not buying Mortgage-Backed Securities, but looking to reduce their holdings, since many of these would have likely been low-yielding investments accumulated during a time of record low mortgage rates. Pushing more supply of mortgage bonds into a market that really didn't want them served to press mortgage rates higher. At the same time, concerns of a forthcoming recession (with impacts on mortgage payment delinquencies and defaults) made holding MBS somewhat riskier, or at least presented the aura of risk that needed to be hedged against. This contributed to a flagging appetite for MBS. but by the latter part of 2023, if became more certain that a recession wasn't coming anytime very soon.

In the mid and latter parts of last year, with mortgage rates rising, originations of new loans dried up, so fewer MBS were issued. Those that were created featured considerably higher yields than had been available for years, and so were in slightly greater demand, with banks beginning to more actively accumulate them again. For bonds, less supply amid more demand increases prices, which in turn lowers yields somewhat, and yields are what help influence mortgage rates up and down. So in addition to long-term interest rates falling since early November, mortgages got a little additional downward push from improved MBS demand.

With rates down considerably after recent peaks and originations picking up a little bit, somewhat greater numbers of MBS are likely to appear in the markets over the next while. It's not clear if additional supply will be met commensurate additional demand, and if not, this would tend to keep mortgage rates from having much space to fall.

There were other technical factors playing a role in the fall decline in rates, too. Spreads between the influential 10-year Treasury and retail mortgage rates have been running extraordinarily wide since about March 2022, when the Fed first outlined plans for reducing its holdings of MBS and stopped actively buying them. After that, the private market was on its own to absorb all new bonds being issued; spreads ballooned amid few takers but plenty of MBS being produced (as retail mortgage rates still only at about five percent during this time). Spreads moved up from a typical 160-180 basis points to over 300 basis points by October 2022, and then had actually retreated to about 245bps before last spring's banking failures shook the markets. Since then, a Fed raising rates further (and promising more), wobbly financial markets and recession worries widened spreads again.

With the risk of recession less of a concern of late, and with bank balance sheets seemingly in okay shape (commercial real estate holdings notwithstanding) yield spreads have begun to contract again, perhaps enhanced by the prospect of lower market rates ahead.

Another item that helped long-term rates decline since November had nothing to do with the Fed, but rather with the Treasury. Part of the reason for the run-up in longer yields in the late summer and early fall was due to the Treasury increasing the supply of longer-term bonds in its quarterly refunding operation back in August. The increase in supply was met with only tepid demand, and yields rose to try to attract investors to buy the glut of debt. As well, Treasury had originally planned to further increase the number of longer-term bonds again in November, but then changed its mind, choosing instead to release more short-term notes that investors were readily snapping up. A change in the mix of government debt being put into the market helped longer-term rates to settle over the end of 2023.

So these factors -- a dearth of MBS supply, an improved appetite for MBS, declining future risk factors and a change in the amount of long-term Treasury bonds that investors needed to absorb -- all contributed to the considerable decline in mortgage rates over the last few months. Of those, perhaps the one that could possibly still have space to run would be yield spreads continuing to shrink, but this depends upon recession concerns diminishing further, ongoing improvement of bank balance sheets and greater competition for the MBS that do come to market. None of these seems impossible, but that's not to say any are likely or would occur at such a pace as to allow mortgage rates to fall much in the immediate future.

We often caution borrowers that the lowest interest rates often come during the worst economic conditions, something no one should wish for. Should conditions deteriorate -- growth slows, unemployment kicks higher, etc -- that would be a precursor to lower mortgage rates. Since we don't have those at the moment -- quite the opposite, in fact -- it's a little difficult to expect that sharply lower mortgage rates are in the offing anytime soon.

A side note: As a longer-range concept, something else to ponder is "what constitutes normal?" as it pertains to monetary policy and mortgage rates. If a "normal" federal funds rate is perhaps 2.5%, (see early 2005, 2008, 2018), mortgage rates might "normalize" anywhere from just below 5% (2018) to something around the 6% range (2008, start of the financial crisis) to the mid-fives (2005), so there are a range of possible outcomes for this cycle. Importantly, none of those sees rates back even close to the then-historic lows of 2012, 2016 or the all-time lows of 2021.

Forecast
Presently, it doesn't seem to us that significantly lower mortgage rates will be coming over the next couple of months. There is of course a chance that they move a little lower than their current stance, with this hinging on inflation continuing to trend toward the Fed's 2% core PCE goal. While the last six months or so have been a step in the right direction, inflation isn't quite there just yet. By March, provided the present trend continues, core PCE will have been around the 2% mark for about nine months, possibly enough for the Fed to make a move, but perhaps a period of low inflation closer to a year might be more to the central bank's liking. Certainly, we'll know soon enough.

Meanwhile, the economy seems to be powering along, labor markets remain tight and wages and service prices are still at a level that may make further progress on core inflation more challenging than it has been so far. That said, just as the downside for rates to us seems limited over the next nine weeks, the upside appears nearly as limited. While the technical factors described above could of course exert their influence on mortgage rates, or some outside surprise could come to disturb financial markets, there's no way of knowing if any of these will do so over the forecast period.

We think that over the next nine week period, the average offered rate for a conforming 30-year fixed-rate mortgage as reported by Freddie Mac will run in a range of 6.35% to 6.89%. For a hybrid 5/1 ARM, we expect to see a 5.85% to 6.40% pair of fences containing the most common alternative to a long-term fixed-rate mortgage.

This forecast expires on March 29, 2024, just a day after the opening of the major league baseball season. Check back to see if this latest forecast turned out to be a foul ball, a home run... or a strikeout.

Between now and then, interim forecast updates and market commentary can be seen in our weekly MarketTrends newsletter. You can sign up to get MarketTrends by email, too.

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