5/17/2022 | No surprise, interest rates are up. What is surprising is that they have gone up faster and farther than I’ve seen before in my time in the industry. (That’s, umm, well, a long time.)
How high have they gone up, and will it last?
The three most important factors in interest rates are inflation, inflation and inflation. More accurately, it’s the expectation of inflation over the life of a contemplated investment.
The news has been pretty clear recently; the consumer price index (CPI) tells us that prices are rising. But those of us who buy groceries or gas or pay rent already knew that, didn’t we? The Federal Reserve Bank (The Fed) has been claiming that inflation was “transitory,” meaning it wouldn’t last. But so far it has. Only time will tell.
I track three different indices to take a backward look at mortgage interest rates in order to predict the future direction. I consider the 10-Year T-Bill, Fannie Mae 60-day yield, and the Freddie Mac Mortgage Market Survey.
Read more: How Can I Track Mortgage Interest Rates?
Let’s take a look at where interest rates have been and where they’re going.
Interest Rates in Recent History
You already know that we had historically low interest rates over the last two years. Looking at the chart below, you can see rates were low in late 2020, rose higher in the spring of 2021, and then came back down throughout the summer. They began moving up again in the fall, and then rose steeply in January when it became clear that inflation might not be transitory.
Looking at the red line – the 10-Year T-Bill – you’ll notice that investors react pretty quickly to news reports. This is what makes this index so valuable to tracking long-term interest rates.
The blue line – the Fannie Mae 60-day yield – follows the T-Bills pretty closely, but you’ll notice that when the T-Bills move up sharply the 60-day yield reacts quickly and dramatically. As the T-Bill recovers and begins sliding down, however, it declines more slowly. Remember that mortgages are a riskier investment than T-Bills, so investors tend to be cautious about accepting lower yields.
When we get to the green line – representing the rates borrowers actually got, it tends to be even more dramatic, as lenders don’t want to get caught with mortgages that they can’t sell for a profit. Lenders increase their margin to mitigate risk, and only bring margins back down carefully. This is why we say rates jump up, but settle down.
Lenders Improve Their Pricing with Thinner Margins
What affects lender margins? Risk and capacity. When lenders aren’t sure where interest rates might go, they tend to increase their margins to compensate for risk. As interest rates settle into a predictable pattern, lenders tend to improve pricing as the market risk decreases.
A bigger influence, however, is their production capacity. The mortgage industry has dramatic surges in business. Lenders expand their capacity when a surge hits, but it’s not easy to do that quickly. When applications overrun production capacity, lenders raise margins because, well, they can, and so as not to overload their systems. We can actually see when this happens.
This chart measures the interest rate spread between the 60-Day Yield and the Mortgage Market Survey – effectively giving us a proxy for lender margins. We had low margins throughout most of 2020, because lenders had expanded production capacity rapidly and wholesale interest rates were stable. In late 2020 interest rates began to rise, so applications fell off. You can see a clear compression in lender margins as lenders found they had less business than they had the capacity to manage. Competition drove margins down.
When Interest Rates are Stable, Margins are Too.
The margin remained quite level through an unusually long streak through 2021, at a time when interest rates remained low and stable. (Laissez le bon temps roulez!) By October, interest rates began showing signs of instability, and look what happened to margins. The blue line gets very noisy as lenders hunt for that just-right margin – high enough to make a profit, low enough to be competitive, while dealing with the risk of wildly fluctuating wholesale interest rates.
Margins rose a little in December and January because the direction of interest rates was getting harder to predict, but they still needed to keep their operations busy, so not too much. By February you can see the wild fluctuations clearly, but the very clear trend in lender margins is downward. Interest rates are getting much harder to predict, but application volume is way down and lenders need to remain competitive.
But then in March, something interesting happens. Margins began rising again, even as lenders were struggling to keep their pipelines full. Why? Lenders sell their loans after they’ve made them. The pool of buyers for mortgage-backed securities is shrinking. Lenders can’t deliver loans with too low a margin, or they’ll lose money on every loan.
So right now lenders are searching for the right margin. The result is extreme volatility, which you can see in the graph. Even the 30-day moving average is clearly unstable. Lenders are laying off production staff and reorganizing to maximize efficiency, knowing that the lenders who survive will be the ones who get the reorg and margin right. The industry is in a bot of chaos right now, but it always settles out in a few months.
Interest Rates Today
As of this writing we are dealing with inflation reports, an economy that could surge or fall flat, and a war in Europe. I have never been less certain about the direction of interest rates. Inflation is likely to keep the wholesale cost of money from falling, and lender margins can’t compress much further without putting many out of business. So, the odds of interest rates improving are very low. For now, however, it doesn’t look like they’ll go up much more, either, depending on what action the Fed takes in the next week or two, and what happens in the Ukraine.
Either way, it’s likely to be a very bumpy ride. But this bumpy ride should not stop you.
If you are in the market to refinance, rates are still low from an historical perspective. If you are in the market to purchase a home, we should have a long discussion about the strategy that is right for you.
Casey Fleming, Mortgage Advisor and Author of The Loan Guide: How to Get the Best Possible Mortgage
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About Casey Fleming: Casey Fleming is a veteran mortgage advisor (NMLS 344375) and Author of The Loan Guide: How to Get the Best Possible Mortgage. Casey advises clients throughout California, and is based in the heart of Silicon Valley. He writes articles regularly for several online publications, is a subject-matter expert for two prominent finance-related sites, and is regularly quoted in articles for many other publications.
This article represents the opinions of Casey Fleming, and not necessarily those of Fairway Independent Mortgage Corp. This analysis was prepared with the best information available at the time it was written. Neither Casey Fleming, nor Fairway Independent Mortgage 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 Fairway Independent Mortgage 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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