Today, there’s a lot of discussion happening around interest rates. In particular, how interest rates affect various types of loans is something that directly impacts most of us. Among the most important factors investors are keenly watching right now are mortgage rates, for various reasons.
How mortgage rates move is a rather complex subject, and it is one that’s rather interesting to dive into. Most investors may think that mortgage rates are a direct function of central bank interest rate hikes, which isn’t exactly true. However, the Federal Reserve’s decision to hike rates does impact mortgage rates substantially.
Taking a step back, it’s important to consider why the Federal Reserve raised its benchmark rate. Additionally, we should also look at what the benchmark rate is, for context.
Rising inflation and concerns about out of control costs are the primary drivers of this interest rate hike. In addition to yesterday’s hike, the Federal Reserve choreographed six more hikes for this year. That would bring the benchmark overnight rate to the 1.75%-2% range at year’s end, if these seven hikes take place. Prior to yesterday, the benchmark range was between 0% and 0.25%.
The overnight rate is what banks pay to lend to each other. It’s the shortest-term interest rate out there, and various short-term investments such as treasury bills and commercial paper are impacted by this move.
However, it’s longer-term bonds that really matter for mortgage rates. Let’s dive into how mortgage rates work and why they’re rising right now.
What’s Driving Mortgage Rates Right Now?
Mortgage rates tend to be based off of the 10-year and 30-year bond yields. These longer-dated bonds provide the benchmark for long-term lending products, such as mortgages.
For a financial institution operating in the mortgage business, lending out money over a 30-year period can take many forms. One of the simplest transactions that can take place in this business is for a lender to short a 30-year bond and lend the proceeds via a mortgage. By shorting a 30-year bond, a financial institution will receive a given sum of money and be required to pay back the interest payments over time, in addition to the principal at the end of the term. The lender will pocket the difference between the 3o-year yield (what they need to pay) and the mortgage rate (what they receive). This is what’s known as a net interest margin.
Thus, it’s the longer end of the yield curve that matters in the mortgage business. We’re seeing the shorter end (benchmark rate and one-year and two-year bonds) rise faster than the long end. This can (and likely will) lead to yield curve inversion, which is a key recession indicator. But in general, rising short-term bond yields tend to flow through to longer-date bonds. That’s what we’re seeing now — a rising tide lifting all boats.
For the week ended Mar. 17, mortgage rates ticked up to 4.16%. This compares to 3.09% one year ago. Much of this has to do with higher long-dated bond yields and expectations that yields will rise over time. Should this hiking schedule continue on its path, more pain for new home buyers could be on the horizon. Accordingly, the amount of mortgage one can afford is likely to drop, which could flow through to real estate values. While we’re not seeing that yet, it’s something to keep an eye on, as the Fed looks to cool the economy.
On the date of publication, Chris MacDonald did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.