Mortgage rates are closely linked to the yield on 10-year Treasury bonds rather than the federal funds rate, although investor expectations regarding Federal Reserve monetary policy play a significant role in the bond market. Currently, the gap between the 30-year fixed mortgage rate and the 10-year Treasury yield contributes to the elevated mortgage rates we are witnessing.
As the economy shows signs of cooling and if the spread between mortgage rates and Treasury yields narrows, we might see a decline in mortgage rates in the future. The Federal Reserve, which began decreasing the federal funds rate in September 2024 after a series of increases in 2022 and 2023, has not managed to bring down mortgage rates simultaneously, which is a source of confusion for many.
Understanding the distinction between the federal funds rate and mortgage rates is critical. The federal funds rate, determined by the Federal Open Market Committee, is a short-term rate for bank lending. In contrast, mortgage rates are influenced primarily by the bond market, specifically the yield on 10-year Treasury bonds. Typically, a spread of 1.5 to 2 percentage points is added to the Treasury yield to account for the greater risk associated with mortgages.
Recent spikes in the mortgage-Treasury spread, which has been observed between 2.5 and 3 percentage points, can be attributed to diminished investor appetite for mortgage-backed securities (MBS) since the COVID-19 pandemic, along with concerns over borrowing duration and prepayment risks. Though there was a slight decrease in spreads in 2024, they still remain high compared to pre-pandemic levels.
The yield on 10-year Treasury bonds is largely determined by investor demand, influenced by several macroeconomic factors such as economic growth, inflation expectations, and the Federal Reserve’s monetary policy decisions. This makes the current high rates of mortgage and Treasury yields a reflection of ongoing economic vitality, as many investors are opting for higher returns available from stocks rather than safer bonds.
Looking forward, mortgage rates may decline if inflation continues to ease and unemployment rises. With expectations of a potential recession, a shift in investor behavior could see increased demand for government bonds, leading to lower mortgage rates. If the spread between mortgage rates and Treasury yields narrows, perhaps driven by renewed investor confidence in the housing market or Federal Reserve actions, we could also see some relief for homebuyers.
In conclusion, while current economic indicators suggest challenging conditions for lowering mortgage rates, there is a glimmer of hope for future declines if certain economic factors align favorably. Homebuyers should remain mindful that owning a home encompasses various benefits beyond just the mortgage rate itself.