More evidence lower mortgage rates should be on their way
At the beginning of summer, We wrote a fun Top Gun themed post about how inverted “yield curves” are an indicator that lower mortgage rates are on their way (click on the link above for a refresher).
As we now approach the end of summer, We’re doubling down on our projection based on another rare occurrence in the financial markets. Hear us out, check out the new charts, and let us know if you agree.
For those of us in the mortgage industry, it’s no secret that mortgage rates are closely correlated to the rates of US bonds. Here is a 40-year chart that shows these rates go up & down together.
But they don’t always go up & down by the SAME AMOUNTS. Investors of mortgages (blue line) always command a higher rate of return than a US Bond (red line). Why? Risk. Investors feel its more likely a homeowner will default on their mortgage debt than the US government will default on their debt (debatable, we know, but not for this post). Whenever an investor takes on more risk, they want more return.
Here is a chart that combines the blue and red lines from above into a simple visual showing the difference (or “spread”) between the two rates over time.
Over this same 40-yr period, the typical spread has been between 1.5%-2.0%, with a median of 1.67%. There have been a few instances when this margin has increased to over 2% during uncertain economic times (DotCom bubble, 9/11, Covid lockdowns). And when this spread increases to drastic levels over 2.5% it very quickly boomerangs back to levels below the orange line. But recently the spread has been hovering around 3%, nearly twice the historical norm and unprecedented during this time frame. Why??? Same answer…RISK! But a different kind of risk…prepayment risk.
Mortgage investments are a little different from government bonds in that most investors don’t expect a 30-yr mortgage to be a 30-yr investment. Many scenarios could cause a mortgage to be paid off ahead of schedule (sell the home, refinance, etc.). And the sooner a mortgage is paid off, more risk to the investor via stunted returns. The unprecedented, sustained level of the spread at nearly 3% is proof investors see high risk in buying mortgages in today’s market. It’s clearly not due to foreclosure risk (those levels just hit 40+ year lows). Rather, it’s due to prepayment risk, as investors anticipate refinance opportunities for current borrowers when mortgage rates fall in the near future.
Let’s recap:
- The spread between mortgage rates and bond rates is crazy-high – when a metric is this out of whack, don’t expect it to stay that way for long
- Investors see increased risk in mortgages due to refinances in the near future – the simple fact smart investors think new mortgages will have short shelf-lives is very telling
- Either mortgage rates need to fall or US bond rates need to rise to bring the spread back in line with historical norms – Given that inflation is trending down and stock markets are already approaching all-time highs, it’s a safe bet bond rates won’t rise dramatically. Instead, expect mortgage rates to fall.
Dow Jones is near its all-time high
Inflation has returned to normal
The investors, and ultimately the financial markets, are telling us that mortgage rates will be falling. And likely they’ll be falling sooner than later. We will be keeping an eye on this market indicator, among others, as we track the mortgage and real estate markets. What will be important to forecast is what may happen when mortgage rates do finally fall. Do you have any guesses? You know WE do!!! Stay tuned for more economic insight and projections. Thanks as always for reading.