According to the Mortgage Interest Rate Survey produced by the Federal Housing Finance Agency, contract rates on 30-Year fixed rate mortgages ticked up one basis point in December 2017 to 4.01 percent. Information provided by Freddie Mac, a more commonly used series, showed a similar trend over the month of December with its contract rate on the 30-Year fixed rate mortgage rising by 3 basis points to 3.95 percent.
The results from Freddie Mac’s Primary Mortgage Market Survey (PMMS) also indicate that rates rose an additional 8 basis points in January 2018 to 4.03 percent. According to the PMMS, mortgage rates have risen for 4 consecutive months, climbing by 23 basis points over that period. However, mortgage rates remain below their more recent peak of 4.18 percent established nearly one year ago.
Mortgage rates historically track the 10-Year Treasury note rate and foreign holdings of longer-term U.S. Treasury securities, a measure of foreign demand for these securities, generally tracks trends in 10-Year Treasury note rate (holdings are inverted in the figure below). This suggests that a potential increase in the supply of long-term bonds in part to finance the tax cuts, could push up longer-term interest rates unless demand for these securities grows as well.
At the same time, previous posts have decomposed the rate on the 30-Year fixed rate mortgage into the rate on the 10-Year Treasury note and the mortgage risk premium, the mortgage rate residual after accounting for the 10-Year Treasury note rate. The 10-Year Treasury note rate can reflect the sum of the 3-month Treasury rate bill and the yield curve, or the spread between 10-Treasury note rate and the 3-month Treasury bill rate. Previous analysis demonstrated that the 3-month Treasury bill closely tracks the federal funds rate while the yield curve has historically signaled the onset of a recession.
A second approach to the 10-Year Treasury note rate has been to divide it into the real yield, which is taken from the rate on 10-Year Treasury Inflation Protected Securities (TIPS) and inflation compensation, the 10-Year Treasury note rate residual after accounting for the real yield from the 10-Year TIPS. The real yield has been shown to track an estimation of the underlying strength of the economy, but has also been shown to parallel changes in the Fed balance sheet. Inflation compensation has returned as a reasonable measure for inflation expectations, a key determinant of consumer inflation.
According to Freddie Mac’s estimate, mortgage rates rose by 8 basis points to 4.03 percent. While an assessment of the yield curve doesn’t give a clear answer, because both the 3-month Treasury bill rate and the yield curve rose by 9 basis points, inflation compensation was the main driver. Financial markets’ expectations of inflation rose by 14 basis points over the month of January while the real yield rose by 4 basis points. However, the 18 basis point increase in the 10-Year Treasury note rate was partially offset by a 10 basis points decline in the mortgage risk premium. As expected, the real yield rose, likely reflecting the acceleration of balance sheet normalization in January and inflation compensation may have responded to the expected impact of the recently passed Tax Cuts and Jobs Act when the unemployment rate is low. Additionally, the improved strength in the longer-term potential for the economy coincided with a shrinking of the risk premium associated with mortgage lending.
However, mortgage rates have been rising since September 2017 according to estimates by Freddie Mac. Since September 2017, mortgage rates have risen by 23 basis points. As illustrated by the figure above, the increase in mortgage rates reflects a 38 basis point increase in the 3-month Treasury bill rate. Since the 3-month Treasury bill rate closely tracks the federal funds rate, then it’s reasonable to deduce that the increase in mortgage rates largely reflects monetary policy, both the December 2017 increase in the federal funds rate and financial markets’ expectation of an increase at the March FOMC meeting. In addition, the increase in the 10-Year Treasury note rate reflecting the Fed’s belief that the economy has strengthened was offset by a 15 basis point decline in the risk premium associated with mortgage lending.
Over a longer period of time, since the last recession ended in June 2009, mortgage rates have been lower. The figure above indicates that the mortgage risk premium has remained about steady over this period. However, between June 2009 and the taper tantrum in 2013, the yield curve was flattening because the real yield was falling. After a steepening of the yield curve in response to the taper tantrum, which was shown to have pushed the real yield from negative territory to positive territory, the curve began to flatten, reflecting a combination of inflation compensation and the real yield at different points in time. More importantly, since 2015, the decline in the yield curve has largely offset the increase in the 3-month Treasury bill rate, a proxy for the federal funds rate. Today’s employment release indicates that short-term rates will continue to rise and it suggests that the yield curve may steepen, possibly combining to push up longer-term rates.