Eye On Housing
The Federal Housing Finance Agency reported that mortgage contract rates on purchases of newly built homes rose by 11 basis points over the month of February to 4.14 percent, near its last peak level of 4.18 percent established one year ago in February 2017. Over the past year, the average mortgage rate on purchases of newly constructed homes fell by 25 basis points to 3.93 percent in October 2017. Since October, rates have risen by 21 basis points.
A more widely used estimate of mortgage rates from Freddie Mac’s Primary Mortgage Market Survey (PMMS) illustrates that rates rose in February and climbed by an additional 11 basis points in March to reach 4.44 percent. Mortgage rates estimated by this survey have been rising since September 2017. Since September, mortgage rates have risen by 64 basis points, largely reflecting the increase in short-term rates, which are most sensitive to the federal funds rate. Going forward, information from the Fed’s last meeting indicates that monetary policy will continue to exert upward pressure on mortgage rates, at least through 2020. However, the exact impact of short-term rates on longer-term mortgage rates will also be affected by changes in the yield curve and on the performance of the mortgage risk premium.
Although mortgage rates continue to rise, the reason for the month-over-month increase has shifted. A previous post illustrated that the increase in mortgage rates over the month of January reflected a higher compensation for inflation over a 10-year period. Earlier NAHB analysis has demonstrated that 10-Year inflation compensation has returned as a reasonable measure of inflation expectations. Over the month of March, both 10-Year inflation compensation and the real yield on the 10-Year Treasury note, obtained from the rate on 10-Year Treasury Inflation Protected Securities (TIPS), were nearly flat, each falling by one basis point.
Instead, larger changes over the month were observed in the 3-month Treasury bill rate and the difference between the 10-Year Treasury note rate and the 3-month Treasury bill rate, a measure of the yield curve. In March, the rate on the 3-month Treasury bill rose by 14 basis points. NAHB analysis has shown that the 3-month Treasury bill rate tracks the federal funds rate closely, indicating that the March increase reflected either actual or expected monetary policy actions. Since the yield on the 3-month Treasury bill rate rose, but the rate on the 10-year Treasury note remained about steady, then the difference between the two, which we call the yield curve, “flattened” by 16 basis points. One interpretation of the decline in the yield curve is that the probability of a recession over the next 12-18 months increased, in contrast to the rate change in January which included an increase in the yield curve, signaling that the probability of a recession shrunk. In addition, these changes indicate that the increase in short-term rates did not impact longer-term rates because the flattening yield curve was offsetting. An interpretation of these offsetting dynamics is that current economic conditions are improving, but the risk of a future recession may have also increased.
Instead, mortgage rates rose over the month because the mortgage risk premium increased by 13 basis points. The mortgage risk premium, estimated as the difference between the 30-Year fixed-rate mortgage from Freddie Mac and the yield on the 10-Year Treasury note, is the additional yield assessed on mortgage borrowers reflecting the added risks (e.g. default risk) that the average borrower represents over the federal government. Taken together, one interpretation is that the new round of tariffs, which were announced on March 1st, and the trade war that could ensue, may have muted expectations for the economy’s longer-term potential, keeping the 10-Year Treasury rate about steady (a 2 bp decline in March) when it had been rising, flattening the yield curve (raising the risk of a future recession) in the face of tighter monetary policy (higher short-term rates), and raising the mortgage risk premium (due to prospects of weaker growth in the future). In contrast, the interpretation of the mortgage rate increase in January was that the Tax Cuts and Jobs Act may have contributed to expectations of faster inflation (due to a tight labor market) and, to a lesser degree, the real return on the 10-Year Treasury rate (due to a strengthening of the economy’s potential), but, prospects of a stronger economy pushed down the mortgage risk premium, partially offsetting the increase in the 10-Year US Treasury rate over that month.
However, Freddie Mac’s estimate of mortgage rates has been rising since September 2017. The figure above illustrates that the 64 basis point increase in mortgage rates reflects a 68 basis point increase in the 3-month Treasury bill rate. Since this short-term rate is sensitive to the federal funds rate, it suggests that monetary policy actions in response to a strengthening economy are raising mortgage rates over this longer period of time.
Going forward, information from the Fed’ last meeting indicates that the median FOMC member expects the federal funds rate to rise in 2018, 2019, and in 2020, suggesting that the 3-month Treasury bill rate should rise similarly. However, there is some evidence that these signals from the Fed have not yet been fully priced into financial markets. If actual economic conditions evolve in a manner that the current median FOMC member expects, then over the next three years, monetary policy will exert upward pressure on mortgage rates. However, the exact impact of short-term rates (i.e. current economic conditions) on longer-term mortgage rates will also be affected by changes in the yield curve and on the performance of the mortgage risk premium (e.g. risk of future recession).
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