Mortgage rates have retreated somewhat since their 2023 peak but remain higher than what we would normally expect.
We see this in the interest rate spread between the Freddie Mac national average mortgage rate that is trading at 6.8% and the 10-year Treasury bond yield trading at 4.4%.
Mortgage rates are determined as a spread relative to their benchmark, 10-year Treasury interest rates.
That spread ballooned to as high as 3.2 percentage points in 2022-23 and has recently dropped to 2.7 percentage points. Despite the improvement, that spread remains significantly higher than its 1.8 pre-crisis average.
What accounts for that spread widening?
First, long-term interest rates in general are experiencing a selloff. The investment community is pulling back on its exposure to longer-duration securities that carry the risk of an economic slowdown.
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Second, there is the so-called sell-U.S. trade, with global investors pulling back on their exposure to dollar-denominated debt. This is in anticipation of the U.S. authorities increasing the level and expense of carrying government debt.
Third, a mortgage carries the risk of default, with households unable to meet their expenses if economic growth stalls and unemployment rises.
Fourth, the Federal Reserve has been drawing down its holdings of mortgage-backed securities as part of its so-called quantitative tightening program. The Fed still has $2.1 trillion of mortgage-backed securities in its holdings, but there is one less active participant buying securities in the MBS market.
Finally, the Fed seems less likely to ease monetary policy for an economy still operating at expansive rates of growth and with the threat of inflation hanging over it.
Though the interest rate of a long-duration security would ordinarily be less responsive to changes in the Fed’s overnight policy rate, the interest rate of a mortgage-backed security is determined as a spread over 10-year Treasury bonds, which have closely followed expectations of the federal funds rate.
