The bond market poses a bigger problem for the housing industry currently. Spreads between treasuries and mortgage rates suggest ongoing economic challenges for homebuyers despite the Federal Reserve’s near-end of interest-rate hikes.
Lawrence Yun, the chief economist for the National Association of Realtors, holds a significant stake in the Federal Reserve’s actions. The Federal Reserve aims to control inflation through higher interest rates, affecting Yun’s industry.
The mortgage spread, which was earlier around 1.75 percentage points, is now over 3 percentage points, propping up mortgage rates and affecting homebuyers.
Lawrence Yun stated that this situation prevents homeowners from selling and buying nicer homes and hurts first-time homebuyers. The 10-year treasury bond significantly influences mortgage pricing. In 2021, the mortgage spread was as low as 1.3 percentage points.
According to Yun, buyers don’t expect 3.5% mortgages to return, but 5.5% rates would entice them.
The Fed’s cessation of buying mortgage securities affects secondary market prices. It leads to pressure on lenders to seek wider spreads from borrowers.
Mortgage Spreads Should Move Lower
The recent good economic news should lead to a sharp decline in mortgage spreads. This will bring relief to homebuyers who faced deteriorating affordability since 2020.
In times of recession fears, spreads traditionally widen, as seen before the 2008 financial crisis. Collapsing spreads revive housing activity post-recession or support the market during crises, as in 2021 with the COVID-19 pandemic. However, after the Fed’s interest rate hikes in March 2022, mortgage rates rose faster than bond yields.
The case for wide spreads in the past year had two reasons: Expectations of a rising 10-year treasury yield due to Fed hikes and fear of a 2023 recession. Both factors are now diminishing, with last week’s inflation report showing consumer prices rose less than 3% in the past 12 months, down from over 9% the previous year.
Low inflation will likely continue into the fall as the government’s housing inflation measure lags behind private market data.
Private market data has been showing lower housing inflation since last summer. The consumer price index is expected to reflect the dip in rents and home prices a year ago by year-end.
The March widening of spreads after Silicon Valley Bank’s failure is now seen in a different context. As inflation remains low, the outlook for spreads and housing activity improves.
A Normal Spread Can Provide Relief to Homebuyers
Reverting the spread between 10-year bonds and mortgages to normal would significantly impact homebuyer payments.
For a $500,000 mortgage at 7% interest, the monthly payment is $3,327 (excluding taxes and insurance).
If rates drop to 5.8% with a 2 percentage-point gap, the monthly payment becomes $2,934. At a spread of 1.5 percentage points, the payment is $2,777.
The change in spread leads to substantial savings in monthly payments for homebuyers. Normalizing the spread benefits buyers and improves affordability in the housing market.
Spreads will Narrow
Bond market and housing experts doubt spreads will narrow or mortgage rates will drop quickly. The Fed will likely raise the Fed funds rate at its July 25-26 meeting.
Futures prices suggest a 96.1% chance of a quarter-point increase, supporting Treasury yields. The rate hike could have implications for mortgage rates and the housing market.
Closing spreads saves the borrower $6,600 annually on mortgage payments. A $500,000 loan typically requires about $150,000 in pretax annual income.
Lawrence Yun emphasizes $600 a month as a significant sum for homeowners. Narrowing spreads last fall stabilized the declining real estate market.
One More Rate Hike on Plan
The Fed plans at least one more rate increase, but a second raise may be delayed or canceled.
Doug Duncan, Fannie Mae’s chief economist, expects inflation to determine the decision. Last week’s slight dip in mortgage rates could persist if inflation remains tame.
Fannie Mae forecasts rates to remain near current levels through 2023. The Mortgage Bankers Association sees the 30-year rate dropping to 5.2 percent next year.
Predicting banks’ reaction to changing spreads is tricky, according to Duncan. Banks must consider potential prepayments if interest rates decrease. Banks may be willing to let spreads fall if mortgages’ value increases, even with prepayments.
US Bank’s senior investment strategy director, Rob Haworth, highlights this impact. Banks may demand larger spreads on loans due to potential quick repayments from refinancing. This anticipation arises from the expectation of falling rates next year.