When it comes to forecasting mortgage interest rates, it can be complicated because there are several factors that influence its rise and fall. While the Federal Funds Rate does not directly dictate mortgage rates, the two are related and the FFR serves as a baseline for interest rates across the entire economy.
As of February 1, 2023 the Federal Reserve raised the target federal funds rate by 25 basis points to a range of 4.5%-4.75%. How does the FFR impact mortgage rates? When we see increases in the fed rate as we have, we can expect to see an increase in bond yields, which in turn increases or keeps mortgage rates high.
Let’s take a closer look the 10-Year Treasury and how it is correlated with mortgage interest rates.
What is the 10-Year Treasury?
Institutional investors, i.e. banks and other financial companies, can lend the government money to support its spending and fiscal obligations and get paid interest plus repayment of the borrowed money in a decade. The yearly interest rate the government pays is the yield. Generally speaking, this is the safest investment because we’re talking about lending to the government— the most credit worthy entity. As of February 1, 2023, the yield on a 10-Year Treasury is 3.52%.
How do banks make money?
Let’s imagine I am a bank. I lend money to the government and get paid the 3.52% annual interest on the amount I lent. Of course, I want to make more money in interest, so I take on riskier loans. Sally, walks in to the bank and wants a loan to purchase a beautiful beach home. Although Sally does have a good credit history, there is still a possibility of default– remember, she isn’t the US Government who I know, without a doubt, will pay me back. To offset set this risk and have a greater potential for reward, I charge more interest. The gap between the yield and mortgage interest rate, also know as the “spread,” typically runs between 1.5 and 2 percentage points.
What does this mean?
If the yield is running at 3.52%, I can almost expect mortgage rates to be above 5%. Given that we are in an economic climate of uncertainty, we are seeing the spread between mortgage rates and bond yields be greater. Makes sense right? From the bank’s perspective, in times of uncertainty there is greater risk.
When the opportunity to lend to the government increases, banks raise interest rates on mortgages to compensate for additional risk on top of the yield they get from lending to US Government. As you can see on the graph below, this is why the 10-Year Treasury and mortgage interest rates are almost directly correlated with one another and typically move in lock-step with one another.