Why Are Mortgage Rates So High?

If you are a potential homebuyer or are directly and indirectly involved in the mortgage and real estate industries, you are highly likely to have been impacted by the consistent rise in mortgage interest rates over the last 18 months. Recent trends show that mortgage rates are continuing their upward trajectory. As mortgage lenders, we frequently encounter a common question, "Why are mortgage rates so high?"

We present four compelling factors driving mortgage rates to their highest levels since 2007. Additionally, we offer insights into the future direction of interest rates from Dr. Lawrence Yun , Chief Economist at the National Association of REALTORS? . During a recent meeting with our President and Chief Customer Experience Officer, Lucky Sandhu , Dr. Yun shared his forecast for mortgage rates in early Spring 2024.

THE FOUR FACTORS THAT ARE DRIVING MORTGAGE RATES

1. Federal Reserve Board Monetary Policy

When the Federal Reserve (the Fed) raises its benchmark short-term interest rates (called the federal funds or the Fed funds rate), it can lead to an increase in overall interest rates across the economy, including mortgage rates. In other words, the short-term Fed funds rate indirectly influences even longer-term interest rates as investors seek a higher rate for longer-term?Treasury notes. To understand the connection between the 10-year Treasury notes and the popular 30-year fixed mortgage rate review the section 'Interest Rate Spread' under Where Rates are Heading?, below.

The Fed has raised the Fed funds rate 11 consecutive times dating back to March 2022, when the Fed funds target rate was effectively 0%. Hence, as the Fed funds rate has increased so have mortgage rates.

2. Inflation Expectations:

Inflation is the arch-enemy of mortgage rates. Inflation, as measured by the Consumer Price Index (CPI) was non-existent for years. However, it became a huge concern as the CPI index surged to 9.1% in June 2022. To put this metric in perspective, the Fed's target inflation rate is 2%. This high inflation was achieved largely due to the Fed's $120 billion in monthly Treasury bond (T-Bond) and mortgage-backed security (MBS) purchases starting in June 2020 in response to the COVID-19 crisis. Essentially, the Fed started printing a lot of money to provide support to a rapidly slumping economy.

Referred to as 'quantitative easing' (QE), the Fed purchases T-Bonds and MBS to bring down long-term interest rates and to prod investors into investments that would spur growth. The only challenge: the Fed went too far and too long with their QE program. By the time they realized that inflation numbers were not 'transitory', as the Fed kept referring during the middle-to-later stages of the pandemic, but more consistent and heading higher, it was too late. As you can see from the graph above, the inflation rate spiked between June 2021 to June 2022.

While the inflation rate has dropped dramatically from 9.1% for the 12-month period ending in June 2022 to 3.2% for the year ending July 2023, thanks to the Fed's 11 consecutive Fed Funds rate increases, it is still higher than their target long-term rate of 2%. The Fed's aggressive attempts to bring inflation back to its target rate are proving to be much harder than anticipated.

3. Economic Indicators:

Economic indicators like unemployment rates, gross domestic product (GDP), and consumer spending send signals to the overall health of the U.S. economy. With the Fed's aggressive actions to raise interest rates and slow down the economic growth engine, many of the best financial analysts predicted that the U.S. economy would be in a recession right now. In fact, the reverse is happening. Low unemployment rates, positive GDP growth, and consumer spending reveal signs of a healthy and humming U.S. economy. If these economic indicators continue to show positive signs, the Feds will have no choice but to continue to raise the Fed funds rate further, which will lead to higher long-term rates in the near future. With GDP showing positive growth and unemployment rates at historic lows, there are no signs of a recession.

4. United States Credit Ratings

On August 1, 2023, Fitch Ratings, a global leader in credit ratings and research lowered the country's credit rating to AA+ from AAA. This decision from Fitch marked the second credit downgrade in U.S. history. Fitch cited the ballooning U.S. debt load and a weakening of governance as the key reasons for its credit downgrade. On top of that, Fitch expects the U.S. to enter a recession later this year, the agency said.

Since yearly spending by the federal government exceeds tax revenue, the U.S. has accrued tens of trillions of dollars in debt, requiring the country to make ongoing payments so that it doesn't default on its outstanding loans.

If U.S. debt continues to grow and the government struggles to address it, consumers could face higher interest rates for loans since the nation and its borrowers would be deemed less trustworthy, they added. That would mean higher costs for borrowing everything from credit cards to mortgages to cars. Hence, the Fitch downgrade is leading to mortgage rates inching to their highest levels in almost two decades.

WHERE ARE MORTGAGE RATES HEADING?

So, with all this challenging news, where is the silver lining for mortgage rates? At Reliance Financial ? we take our professional responsibilities to our customers and partners very seriously. Our President and Chief Customer Experience Officer, Lucky Sandhu, met with Dr.?Lawrence Yun , Chief Economist at the?National Association of REALTORS? this week to discuss the direction of mortgage rates.

Dr. Yun predicts that rates on the benchmark 30-year fixed mortgage will come down to 6% by early Spring 2024. The national average rate on the 30-year fixed currently stands at 7.50%.

Here are the three indicators that Dr. Yun based his prediction on:

1?? Rents Stabilization: Rents are expected to further stabilize, contributing to the moderation of the Consumer Price Index (a critical inflation gauge). This stabilization strengthens the case for the?Federal Reserve Board ?to halt further increases in short-term interest rates.

2?? Banking Challenges: Community banks are grappling with the impact of high-interest rates. Persistently elevated rates could pose additional difficulties for the banking sector. The Federal Reserve will aim to avert potential financial turmoil.

3?? Interest Rate Spread: Currently, the 10-year treasury yield exhibits a historically significant gap compared to the average rate on the 30-year fixed mortgage. Traditionally at around 1.80%, this spread now exceeds 3.00%. This widening interest rate spread, initially driven by elevated inflation concerns, has been gradually diminishing as those fears subside. A narrowing of the spread will help with lower long-term rates ahead.

Conclusion:

The Federal Reserve's monetary policy over the past two years, inflation rate, economic indicators like the GDP and unemployment rate, and even the credit rating of the U.S. have all contributed to mortgage rates surging to their highest levels in almost two decades.

While many new homebuyers grapple with high affordability and while real estate and mortgage industry professionals struggle with low inventory and low transaction levels to support their carriers, there is light ahead. Dr. Lawrence Yun recently provided us with three sound reasons why mortgage rates will drop over the next few months. As always, the actions of the Federal Reserve will also add greatly to the near-term future of mortgage rates. All said, we forecast a bright future for the U.S. housing markets ahead.