Since the Federal Reserve started tightening the money supply in 2022, the 30-year fixed mortgage rate in the United States (U.S.) has jumped to 7%. This spread is around 300 basis points (bps) higher than the 10-year U.S. Treasury yield. In the past, this spread has been stable at around 200 bps; this was true even during the pre-pandemic interest-rate hikes (2016–19) and quantitative tightening (Q.T.) periods (2017–20).
Why is it different this time?
We’ll explain below how the interaction between the Fed’s balance sheet and the balance sheets of local banks is a significant reason why this trend is now broken. Changes in the risk tolerance of large investors (bank and non-bank) and the need for mortgage lenders to make money have led to a passthrough of monetary tightening to mortgage rates faster and bigger than ever.
How the 30-year mortgage rate is put together
Along with the 10-year Treasury yield, the 30-year primary mortgage rate is often used as a measure of how the U.S. economy and financial markets are doing. The difference between this mortgage rate and the return on a U.S. Treasury bond is caused by two things.
The first factor is the yield on the benchmark mortgage-backed securities (MBS) released by Fannie Mae and Freddie Mac, called the “agency MBS basis.” This is based on how willing big investors are to take on mortgage interest rate risks or “warehouse” them on their balance sheets.
The second factor is the “primary-secondary spread,” which is the difference between how much mortgage lenders make and how much they lose. It shows not only how powerful lenders are in the housing market but also how their balance sheets limit their ability to help the real economy.
Think about the 10-year Treasury rates and how each of these factors affects the mortgage spread.
Punch #1: Real rates have caused 10-year U.S. Treasury prices to go up.
Since 2021, inflation has gone up because of too much monetary and fiscal support during the pandemic and supply-side shocks. Until the last few months, it seemed like this inflation would never end. As a result, the Fed has actively tightened monetary policy to slow down inflation and the economy. Ten-year Treasury yields, which were only 50 bps in 2020, are now close to 4%, 350 bps higher.
From a different point of view, the 10-year real rate has gone from a pandemic low of minus 100 bps to a post-GFC (Global Financial Crisis of 2007-08) high of 150 bps. Before the pandemic and even during the rate hike and Q.T. events of the middle of the 2010s, this real rate was only about 50 bps. The rise in accurate rates as a whole has also caused mortgage rates to go up.
Punch #2: A broader base for agency MBS, caused by higher volatility and a change in technicals.
The agency MBS basis can be thought of as the market price of the unique choice that U.S. borrowers have to refinance their mortgages or lock in attractive fixed rates (as is the case right now). The cost of this option goes up the more volatile the market is and the more extensive the range of possible interest rates. Rate hikes and Q.T. in the middle of the 2010s made agency MBS spreads 60–80 bps bigger than they are now.
After March 2022, when monetary tightening started, the 30-day rolling correlation of the agency MBS base to interest-rate volatility (MOVE Index) stayed high, between 60% and 80%, for about a year.
But the “technicals” of the MBS market have changed a lot in recent years. The Fed and local banks are now the biggest holders of this type of asset. Since March 2023, when Silicon Valley Bank (SVB), First Republic Bank, and Signature Bank all failed, a significant change in the way U.S. banks work has taken place. In their wake, the relationship between agency MBS basis and rate volatility has become less intense, as shown by the fact that agency MBS basis is going up and the MOVE Index is going down. On the other hand, the relationship between cause and the opposite of how much regional banks’ stocks are worth has gone up. This relationship reached its highest point of 35 per cent in May 2023, when the regional bank index was at its lowest and the basis was at its highest.
Punch #3: Mortgage lenders’ profit margins are getting more prominent because of low numbers and high volatility.
When it comes to mortgage lender margins, mortgage lending is a high-volume business that makes most of its money from refinancing deals. The economics of most U.S. borrowers who “locked in” at ultra-low rates after the pandemic are hurt by the high mortgage rates of today. As a result, lender volumes have shrunk to purchase deals mainly. Because of this, there aren’t as many home sales, so there’s a lot of competition among mortgage lenders.
Since there is a lot of competition, banks should be ready to lower their margins. But lender margins are better now than during the rate hikes and Q.T. in the middle of the 2010s. Back then, they were between 90 and 100 bps, but now between 110 and 120 bps. A big reason this gap is getting bigger is (again!) higher rate volatility, which makes it more expensive for mortgage lenders to protect their pipelines when they commit to making a loan, see it through to the end, and then securitize it into an MBS. This effect on the balance sheet has been more significant than the effect of competition.
Putting it all together, the balance sheets of banks and the Fed move in the same direction.
But a fourth thing has made the combination of these three effects even more vital.
The GFC, especially the trouble in the housing and mortgage markets, drained banks’ capital and cash flow. At the time, banks were the most significant mortgage providers. The Dodd-Frank Wall Street Reform and Consumer Protection Act and other rules after the GFC have made it more expensive for banks to get into mortgages and MBS. Some banks stopped giving out loans and taking care of mortgages altogether. After the GFC, the Fed used quantitative easing (Q.E.) programmes to help the mortgage and home markets. This filled in the gap. Because of this, the number of mortgages and MBS owned by banks grew slowly and steadily until the middle of the 2010s.
But when the Fed stopped Q.E. and finally started Q.T., other rules, like counting agency MBS as “high-quality liquid assets” when figuring out the liquidity coverage ratio (LCR), made banks want MBS more. This helped keep the MBS market stable. Even though banks had unrecognised losses on their securities positions by the end of the tightening cycle, the total amount of those losses was still less than $75 billion.
From this time until the pandemic, the assets on banks and the Fed’s balance sheets moved in the same direction. Because of the significant stimulus, banks have a lot of insured and uninsured deposits and low-yielding reserves, but there need to be more high-yielding business loans to invest in because demand is low in 2020. Because rates were so soft and the yield curve was flat, banks had to look for ways to make money, so they bought Treasuries and agency MBS instead.
So, the tightening of the money supply after the pandemic of 2022 began with a lot more liquid assets in the hands of the Fed and the banks, whose balance sheets are linked. At the moment, neither of these groups wants to buy a new MBS. This means that the agency MBS basis is driven almost entirely by the risk appetites of institutional buyers who aren’t banks. Since these buyers are much more likely to face rollover risks because the market is more volatile, they ask for higher risk premiums than banks do. This has made the triple punch that monetary tightening gave to mortgage rates even stronger.
What comes next?
An important lesson is that the unprecedented fiscal and monetary stimulus during the pandemic worked through the commercial banking system. This created a path dependence on how monetary tightening is now playing out, especially for mortgage markets.
In a strange way, as mortgage rates go up, workers in the U.S. are less willing to change to meet sectoral needs. This is because ultra-low mortgage rates keep families from moving. In turn, this makes jobs scarce, wages high, and inflation steady.
So, the Fed is stuck between a rock and a hard place because the effects of tightening on the demand side and the supply side are going in opposite ways. In what direction will the pendulum move? It’s hard to say, but this may be why interest rates have stayed so unstable.
