2/21/2020 | Casey Fleming | In December I wrote that most analysts were calling for mortgage rates to dip in late winter or early fall. That gift came a little earlier than expected, but it’s unclear how long it will last. So why are interest rates dropping in February? More importantly, will they go lower? Let’s take a closer look.
As I’ve written before, the three most important factors in interest rates are inflation, inflation and inflation. Inflation has been very tame in the last few years. In fact, it has been lower than investors expected, so interest rates have dropped steadily.
Think of the expectation of inflation as defining the narrow range that establishes long-term trends. If interest rates are dropping, it is because investors don’t believe inflation will rise in the near future.
Look at the chart of interest rates below. From late 2018 through August of 2019 the downward slope of the long-term range is quite clear. (see the red line) Investors started out the year expecting to see inflation rise, but it didn’t. As their expectations adjusted to reality, the yield they demanded dropped steadily.
After August of last year, you can see that the long-term range flattened out. While there is no reason to believe inflation is about to rise, economic indicators still show few signs of an impending recession. So, investors have settled on a range of yields that – for now – reflects their (low) worries about future inflation.
Interest Rates Move Within the Range
Now, notice the small movements within the defined long-term range. Those represent movement driven by news events that create uncertainty in markets. In this case, you can see that it was pretty steady until the last week of January. When the corona virus became news, money moved from stocks into bonds, with interest rates dropping in response.
You can also see, however, that wholesale rates still hit the same hard bottom within the broad range we’ve seen over the last 6 months. Until the expectation of inflation changes, this is most likely the range we will be working within.
Lenders Add Their Profit, Too
You’ll notice there was a slight uptick in retail rates after February 7th, even though retail rates continued to drop. Besides inflation and news-driven movement in interest rates, there is one more factor that helps determine the interest rate you get – that is the margin that lenders want to earn. Look again at the chart above. The green line tracks interest rates that real people actually locked at during the previous week.
The chart below tracks the margin lenders are charging over their cost of funds. Going back to 2019, notice that the margin lenders earned held fairly steady over the first half of last year. As wholesale interest rates dropped, so did retail rates.
But in June things changed briefly. As wholesale rates dropped a little more sharply, lenders followed them down cautiously; retail rates improved more slowly than wholesale rates. This is because lenders want to see an established trend before taking the risk of offering lower interest rates to you.
Margins dropped in July, but then in August – right about when the long-term trend line flattened out – lenders increased their margin. This illustrates the principle that a steady market is good – volatility in the market tends to make lenders nervous, and retail rates rise until lenders get more confident.
Sure enough, you can see that as the interest rate market stabilized in late December / early January, margins came back down a little – until the corona virus scare spooked the markets.
Why Are Interest Rates Dropping in February?
Remember that wholesale interest rates began to drop again in January. (Top chart) The margins, however, rose. This didn’t mean retail interest rates rose. They moved very little, even though the wholesale rates were dropping in response to news-driven events. Retail rates improved slightly, but the higher margin tells us that – if wholesale rates stay low and stabilize – there is room for retail interest rates to come down a bit – somewhere between 0.125% and 0.250%.
Remember, however, that inflation expectations define the trading range of interest rates. Unless expectations about inflation change, interest rates don’t have a lot of room for improvement.
What This Means for You
If you are refinancing an existing loan, get your application in and ready to go, and float your interest rate until you see a nice dip in retail rates, such as we had on February 7th and again 20th to 21st.
If you are in the market to purchase a home you have a defined window in which to work. You can’t float indefinitely, so ask your mortgage advisor about when to lock. Hopefully they will be paying attention to small movements in the wholesale markets so that – within your window of opportunity – you can lock on a day when rates dip down a bit.
What Difference Does It Make?
At any given interest rate, it’s not unusual for pricing to change by 0.25 points or more by locking on the right day. On a $400,000 loan, for example, this means an up-front savings of $1,000 to $2,000 (at any given interest rate.) On an $800,000 loan (more typical in Silicon Valley) this means $2,000 to $4,000 in savings.
You don’t pay anything for these savings. You don’t give up the interest rate you want and you aren’t forced into a loan you’re not comfortable with. It’s free money for taking a chance and playing the game correctly.
Rates are very low right now, and while the long-term trend is flat there are days where you have an opportunity to save thousands of dollars by using a smart strategy. Call me today for a free consultation about your options.
This article represents the opinions of Casey Fleming, and not necessarily those of C2 Financial Corp. This analysis was prepared with the best information available at the time it was written. Neither Casey Fleming, nor C2 Financial Corp., have any magical insider information about bond markets, real estate markets or mortgage markets that would make economic projections any more reliable than any other source. No warranty is made that the outcome will reflect the projections in this article, and neither Casey Fleming nor C2 Financial Corp. are responsible for decisions that you make regarding your own choices about your real estate or mortgage or those of your clients.
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