Interest rates rose when inflatin was high, and now mortgage rates are fallin

Mortgage Rates Are Falling

Casey Fleming

Mortgage rates are falling because the Fed raised interest rates.  That makes more sense than you think.  Yes, I know that when the Fed announces yet another raise in interest rates next week, you’ll see ads screaming “The Fed is raising interest rates! Apply now before rates go up!”  The point of those ads isn’t to inform you, but rather to get you to pick up the phone and call.

Let’s look at what is happening to interest rates and why mortgage rates are falling.  First, remember that the three most important factors in mortgage rates are inflation, inflation and inflation.

For a deeper look: Mortgage Rates and Inflation

As I’ve been telling you all year, mortgage rates are rising because of inflation.  It follows that if inflation is moderating, mortgage rates are falling, too.  And it turns out that’s true.  But why does the Fed raising interest rates make mortgage rates fall?

The reason the Fed raises interest rates is to make things more expensive for consumers to buy, and thus slow down consumer activity.  Slowing down the economy takes pressure off inflation.  The Fed raises rates to fight inflation, so a natural consequence is that mortgage rates are falling because the Fed is raising interest rates.  It’s a little counter-intuitive, but it is so, nonetheless.

For a deeper look: Fed Rate Hike – What Does it Mean?

But Who Sets Mortgage Interest Rates?

Advertising would have you believe that the Fed sets mortgage interest rates, but that’s not true.  There are three different groups that ultimately drive what you pay for your mortgage: institutional investors who invest in mortgage pools, agencies or organization that buy pools of mortgages, and lenders who decide how much money they need to make on a loan.

Let’s Examine These to See Why Mortgage Rates are Falling

Lenders all get their money from the same sources, despite the claims of some that they have a magic pool of money.  Banks, credit unions, mortgage lenders and mortgage brokers all offer you a mortgage knowing who will buy it.  The ultimate purchaser tells the lender what yield (interest rate) they want to make, and that drives the interest rate the lender offers to you.

Who buys the mortgages? Fannie Mae and Freddie Mac (government agencies created specifically for this purpose) and Wall Street hedge funds.  These agencies or organizations set the yield they need to earn based on their cost of funds.

Who determines their cost of funds?  Institutional investors looking to diversify huge investment portfolios.  These institutions might be pension funds, insurance companies, or large mutual funds that include some fixed-income securities in their portfolio mix.

These institutions want to earn enough money to outrun inflation.  (See article above.)  They set what I call the floor price of interest rates.  When they lend money to the agencies and hedge funds by purchasing mortgage-backed securities (in the form of bonds), they set the yield they want.

This sets the floor interest rate.  Then the agencies and hedge funds who buy mortgages have to add their profit margin.  They offer lenders a wholesale interest rate through daily communication.

The lender now has to add their margin to offer you today’s interest rate.  This three-layer process is what determines, or “sets” the mortgage rates you are offered.  Is there any way we can see what these rates are to understand why mortgage rates are falling?  While it’s not perfect, we can actually get pretty close.

Interest Rate Layers

Interest rates rose when inflatin was high, and now mortgage rates are fallin
The “layering” of profit margins that make up your interest rate

Take a look at the graph above.  This chart tracks three different interest rates over time.  The red line tracks the yield on the 10-year U.S. Treasury bills.  This is the most easily tracked index that charts the yield institutional investors want on safe, long-term investments.  The blue line tracks the Fannie Mae 60-day yield, an interest rate published daily that announces what yield Fannie Mae wants to earn.  Finally, the green line charts the Freddie Mac Mortgage Market Survey, a measurement of the average interest rate of mortgages that real consumer actually locked each week across the nation.

The red line shows us that investors were happy with a low yield as long as inflation remained low, and it held fairly steady for many months.  In early 2022, when we first started noticing that inflation was rising, you can see that investors decided they needed to earn a little more on their long-term investments, and the yield began to rise.  In March when data suggested inflation was starting to spiral out of control, you can see a fast ramp up of the interest rates institutional investors were demanding.  We had a little more stability from June through August, and then another steep runup until mid-November.  There are signs that inflation is moderating, and you can see that since the mid-term elections, investors are becoming more comfortable with lower yields.

The blue line shows us something important.  You’ll notice that when the market was calm, Fannie Mae was comfortable with fairly low margins.  But as it became more volatile, margins increased to account for the greater market risk.  Remember, Fannie prices mortgages that they won’t receive for 60 days, so they are taking on some risk offering any mortgages at all.

The green line shows us that lenders were making a pretty comfortable margin in 2021.  They had plenty of business, so a nice fat margin made sense.  As the market slowed down toward the end of 2021 and lenders became hungry for business, margins compressed as lenders competed more and more aggressively.

After a Steep Rise, Mortgage Rates are Falling Now

The margins lenders add changes over time
Mortgage rates are falling, but lender margins are increasing

This chart tracks the retail margin lenders charge over time, and confirms our observations from the first chart.  Lenders were making fat profits in 2021, but their margin declined dramatically as business fell off and they had to compete for your mortgage.  You’ll also notice that margins became more volatile, indicating that lenders are still trying to find that sweet spot where they can pay their bills and hopefully make a profit while still being competitive.

Notice that in the last month as the wholesale cost of mortgages has declined, lenders have not followed the rates down as quickly as they could.  There have been a lot of layoffs in the industry over the last nine months or so, so this trend could indicate either than there are fewer lenders and thus less competition, or it could be that lenders are reluctant to take the risk of chasing rates down too quickly.  This is why I usually say that mortgage rates jump up, but settle down.  When mortgage rates are falling, lenders follow them down tentatively.

Finally, let’s take a look forward.  We’ve been talking about how investors determine the yield they need by looking at inflation, but what do they look at?  The Consumer Price Index (CPI) is the statistic most often quoted, but that’s a measurement of inflation last month.  Investors are concerned about where inflation will go over the next ten years or so.  So, they look at forward-looking statistics, such as unemployment claims, the jobs report, wages, factory orders, etc.  Almost all of these indices are (finally) showing a decline in economic growth these days, indicating that inflation will likely moderate.  The October CPI, while still high, does in fact show that prices are not rising as fast as they were.

The Fed sees this.  They meet next week (December 14th) to discuss whether to raise short-term interest rates again and what to say about their plans in the coming year.  They’ve been raising rates aggressively – 0.75% each of the last three meetings.  Will that continue?  They absolutely want to be sure to send a signal to investors that they remain serious about fighting inflation.

Is the Fed Concerned That Mortgage Rates are Falling?

In a way, yes.  Falling mortgage rates could spur home-buying activity, which is good for the economy, but they are trying to slow down the economy.  However, remember – they do not control mortgage rates.  My guess is that they will raise short-term interest rate 0.50%.  In their comments they will note that they see signs of inflation moderating, but remain concerned and committed to getting inflation back down under 3% per year, hopefully without pushing the country into a recession or increasing the unemployment rate.  At this point, however, some economic pain is better than continued inflation, at least in their minds.

Mortgage Rates Are Falling

This combination of moderating their choking of the economy while reasserting their commitment to keep fighting inflation will, I believe, give investors enough confidence moving forward to lower their expectations as far as yield goes.  The floor cost of funds, therefore, will come down a little in the next month.  Watch the 10-year yield.  (Stock symbol TNX)  The only questions is whether Fannie Mae, Freddie Mac, Wall Street Hedge funds and lenders will follow suit and drop their rates, too.  Over time, it’s inevitable, so look for lower mortgage rates in 2023.


Casey Fleming, Mortgage Advisor and Author of The Loan Guide: How to Get the Best Possible Mortgage

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 any company or organization cited or mentioned in this web site.  This analysis was prepared with the best information available at the time it was written.  We do not 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 the author nor are responsible for decisions that you make regarding your choices about your real estate or mortgage or those of your clients.

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