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The curious case of the enduring sub-3% mortgage rate

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Historically low mortgage rates had their moment in the sun in 2020. They rested far below 3% for months before America’s economic rebound pushed them back up in the winter of 2021. But data released on Thursday from Freddie Mac showed that mortgage rates idled below 3% again for an entire month, even with solid first-quarter GDP figures and encouraging consumer spending numbers.

Mortgage rates may look fickle, but the Treasury market rules them. If the 10-year yield rises it’s most likely the result of inflation expectations picking up, and with them, mortgage rates. When the 10-year-yield drops, inflation expectations are falling. That’s the simple answer.

The world, according to mortgage rate America

While America continues to emerge from the COVID-19 crisis, other parts of the world are very much in the thick of it. A COVID-19 variant first identified in India has even threatened the U.K.’s plans to end lockdowns, Prime Minister Boris Johnson said.

Because the market is still so uneasy globally, U.S. investors relaxed momentum on the bond market, leaving mortgage rates with a better outlook than expected. Most industry experts predicted that rates would have settled far above 3% by now.

“This may be the most complicated 10-year-treasury yield data the market has ever seen, but no matter how good the economic data is, COVID is still here,” said Logan Mohtashami, lead analyst at HousingWire.

“When you look at two other massive economies, Germany and Japan, Germany’s 10-year-yield is in the negative. Our bond yields look much better than theirs so we can’t in a sense be at a 3% mortgage rate when the gap between ours and Germany’s yields are too far apart. There has to be balance.”

Beyond the 10-year-yield, two other yields exist in the market: retail and wholesale that fluctuate in the primary and secondary market, respectively, and which both have tightened recently.

“The reasons for why those spreads might have tightened is simply less frenzied retail market profit margins have come down a little bit in the retail market, and investors are a little bit more willing to bear the optionality of mortgages on the Treasury,” said Bill Emmons, economist for the Federal Reserve of St. Louis.

In wholesale, buyers of federally guaranteed mortgage-backed securities (MBSs) factor two financial components into the price they are willing to pay for MBSs — compensation for the pure time value of the money being invested and compensation for the interest-rate risk associated with mortgage investments, Emmons explained.

While time value is typically approximated by the yield on a Treasury security of equivalent duration i.e. the 10-year Treasury, risk compensation is more effected by mortgage borrowers prepaying their mortgage principal at face value at any time without penalty.

“People that had been looking to invest in treasuries or MBSs last year when yields were so low they were struggling to generate the kind of income they need to fund their liabilities in some cases,” said Mike Fratantoni, chief economist for the Mortgage Bankers Association. “When our yields look much more attractive than those of the rest of the world, mortgage rates get to a level on the investor side that generate a lot more interest, but we are going to go through periods where they plateau or dip back down as we watch the market.”

Keeping an eye on inflation

While investors study the bond numbers in other countries, the Federal Reserve’s adjustments on inflationary policies are keeping them just as busy.

In April, the Federal Open Market Committee left future economic policies virtually unchanged at its monthly meeting, indicating it has not made any near-term plans to taper its asset purchases of Treasury– and mortgage-backed securities while it awaited data on vaccine distribution, employment and inflation numbers.

The Fed mentioned that inflation had in fact “risen” but attributed the higher readings to “transitory factors.”

Overall, while March posted hopeful signs of a recovering economy, Fed Chairman Jerome Powell said it will take a string of good months before the Fed chooses to roll back any monetary policies.

“There is growing concern about what’s happening with inflation,” Fratantoni said. “Consumer inflation expectations are starting to increase as well so or the next couple of months bond investors are going to start to worry a bit more about both the impact of faster growth and faster inflation.”

Despite the lackluster unemployment report in April, the consumer price index still estimated inflation hitting 4.2% on a year over year basis. Typically, mortgage rates respond to this kind of data, and in theory, should have, given the historic number for core inflation as well.

When mortgage rates failed to pick up in the last month, savvy homebuyers jumped back on them. But even with rates slipping to previous lows, borrowers are still battling it out in the bidding trenches on overheated prices. April economic data for home sales showed year over year numbers are still above those in 2020, but beginning to dip sequentially.

“The inflation data should moderate as production levels catch up with the COVID-19 backlog,” Mohtashami said. “So, we have hotter-than-normal inflation data, and rates are still low, even with the rise of the 10-year yield. COVID-19 has kept global bond yields low in 2021, but for 2022, this no longer works as a legitimate reason.”

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