Will mortgage rates rocket even higher in coming months?

Summary

• The rate on the 30-year fixed-rate mortgage has risen significantly since the beginning of the year. It currently sits at 5%, the highest rate in more than three years.
• This benchmark mortgage rate primarily reflects two components: the yield on intermediate- to longer-term Treasury securities and a spread that tends to fluctuate over time.
• The Federal Reserve has held agency mortgage-backed securities (MBS) on its balance sheet since early 2009. We estimate that Fed purchases of these securities have pulled down the yield on the benchmark 30-year MBS by about 50 bps or so on average since 2009.
• Fed officials have indicated they will allow their MBS holdings to decline in coming months. Will this cause mortgage rates to shoot even higher?
• Not necessarily. First, markets are forward-looking, at least to some extent, and recent mortgage spread widening is consistent with markets accounting for smaller Federal Reserve MBS holdings going forward.
• Second, Fed purchases of mortgage-backed securities in recent years have pulled MBS yields lower than actual mortgage rates. As balance sheet runoff progresses at the Federal Reserve, it is reasonable to expect that MBS yields will face more upward pressure than actual mortgage rates.
• But, mortgage rates could continue to trend higher if yields on longer-dated Treasury securities increase further. The open question is how much higher will the yield on the 10-year Treasury note rise?
• There is a significant amount of near-term monetary policy tightening already priced into the market. Longer term, markets appear priced for a fed funds rate that is near our estimate of “neutral.”
• In our view, the recent surge in the 10-year Treasury yield should slow markedly, which should dampen upward pressure on mortgage rates.
• We acknowledge that yields on U.S. Treasury securities could potentially rise even further. The past several months have shown that the economic outlook and expected path of monetary policy can change rapidly.
• In addition, there are wide confidence intervals around estimates for both the timing and the magnitude of the impact from balance sheet runoff, a fact acknowledged by Chair Powell in his press conference after the March 15-16 FOMC meeting.
• We doubt balance sheet runoff has been fully priced in yet, but we suspect it is discounted by more than many might suspect, given that the process has not even yet begun.

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