According to the Federal Housing Finance Agency (FHFA), mortgage rates continue to rise and this is confirmed by data from Freddie Mac. The short end of the yield curve, which is most sensitive to monetary policy, has been the primary force behind the increase in mortgage rates. In recent years, short-term rates have put upward pressure on mortgage rates while the yield curve has largely been flattening since the end of the last recession.
Over a longer period, the trends in the yield curve as well as the mortgage risk premium when mortgages are not the culprit, display persistent and generally stable predictability over the business cycle. Determining the peak federal funds rate over the cycle is the key to estimating the level of mortgage rates at the end of the current business cycle. The peak short-term rate at the end of the business cycle has, since the early 1980s, been below that reached just prior to the previous recession. However, the FOMC currently believes that monetary policy is “accommodative”.
The FHFA reported that mortgage contract rates on purchases of newly built homes rose 19 basis points to 4.33 percent. Since reaching 3.93 percent in October 2017, mortgage rates on newly built homes have climbed 40 basis points. Information provided by Freddie Mac indicates that mortgage rates rose in April as well. According to Freddie Mac, mortgage rates rose by 3 basis points to 4.47 percent. Since falling to 3.81 percent in September 2017, mortgage rates compiled by Freddie Mac have risen 66 basis points.
Compositional analysis of mortgage rates indicates that the 66 basis point increase over the September 2017 to April 2018 period reflects an increase in the 10-Year Treasury Note rate. As illustrated in the figure above, the 10-Year Treasury Note rate has increased by 67 basis points while the mortgage risk premium, which reflects the added risk of mortgage borrowers over the federal government, fell by one basis point.
An assessment of the 10-Year Treasury Note rate indicates that its increase reflects a higher 3-month Treasury bill rate. Meanwhile, one measure of the yield curve, the difference between the 10-Year Treasury Note rate and the 3-month Treasury Bill rate, fell by 7 basis points. Previous analysis illustrated that the 3-month Treasury Bill rate tracks the federal funds rate and is then sensitive to both actual and expected monetary policy decisions while the yield curve has historically signaled a recession 12 to 18 months into the future.
Another approach to analyzing the 10-Year Treasury Note rate is to decompose it into its real yield, taken from the rate on 10-Year Treasury Inflation Protected Securities (TIPS), and inflation compensation, the residual between the 10-Year Treasury Note rate and the 10-Year TIPS. Previous analysis illustrated that inflation compensation has returned as reasonable measure of inflation expectations over a 10 year period while both the economy’s potential growth and the changing size of the Fed’s balance sheet influence the real yield. The figure above indicates that both inflation compensation and the real yield contributed similarly the changes in the 10-Year Treasury Note rate.
Since the final year of the recession, which spanned 2007 to 2009, the 3-month Treasury Bill rate, a proxy for monetary policy, has put upward pressure on mortgage rates in recent years while the yield curve has put downward pressure on mortgage rates. The mortgage risk premium has been about constant over this time period.
Looking over a longer period of time indicates that the primary influence of the 3-month Treasury Bill rate on mortgage rates is historically normal. As shown in the figure above, the long-term trend in mortgage rates largely reflects the path of the 3-month Treasury Bill rate, which is proxy for the federal funds rate. Shorter-term changes in mortgage rates are also determined by the yield curve. However, as the chart above illustrates, the yield curve has consistently, especially since the late 1980s, ranged between -0.52 and 3.40 percentage points. The mortgage risk premium has, especially since the late 1980s, remained near 1.60 percentage points. The increase in the risk premium during the Great Recession reflected the role played by housing and mortgages.
Not only does the figure above suggest that monetary policy plays a key role in the determination of mortgage rates, but it also illustrates that an inverted yield curve is predictive of a future recession. Since the early 1980s, the yield curve trends between 3.40 percentage points and -0.52 percentage points over the business cycle. Taken together, the chart illustrates that, since the 1980s and when mortgages are not at the center of a recession, both the mortgage risk premium and the yield curve settle at historically predictable levels at the end of the business cycle. The 3-month Treasury Bill rate reaches its height at the time as well, corresponding with a low and negative yield curve, but this height has varied. However, since the early 1980’s the height in the 3-month Treasury Bill rate has been below its peak prior to the previous recession. This suggests that the determination of the 10-Year Treasury Note rate, the sum of the 3-month Treasury Bill rate and the yield curve, largely rests on the height of the 3-month Treasury Bill rate at the end of the cycle, but at its height prior to the Great Recession, this rate peaked at 5.08 percent.