July 27, 2022

Fed hikes rates again: Will mortgage rates be next?

On July 27, the Federal Reserve issued a 75-basis point hike to the "Fed Funds Rate," its second such increase in as many months, and the most aggressive hike since 1994.

The “Fed Funds Rate,” is the baseline interest rate banks charge to borrow from each other. When inflation is high, central bank officials use these baseline interest rates as a tool to slow down borrowing, hoping to cool down the economy as a whole. Eventually, the costs tend to trickle down to the banks’ customers.

The recent run-up in inflation can mostly be attributed to the Coronavirus pandemic, which caused distortions on both the demand and supply sides of the economy

Consumer price inflation picked up steam throughout 2021, but many financial officials expected it to relent as Covid-19 concerns waned. Instead, inflation continued to grow - exacerbated by post-pandemic consumer demand, supply issues and the war in Ukraine. By the end of June, inflation was rising at a scorching 9.1%, the fastest since 1981. The Fed is under pressure to raise rates aggressively.

In a June report to Congress, the Fed promised as many hikes as necessary to achieve price stability. This is the fourth rate hike since March.

Given these factors, the Fed's July hike would seem to portend even higher mortgage rates. Over time, mortgage interest rates do tend to move in the same direction as the Fed Funds Rate. But not necessarily. Mortgage rates and the Fed Funds Rate are not the same thing.

To understand this, it is important to understand how mortgage rates are set. The rates on the most common mortgage - the 30-year-fixed - closely follow 10-year Treasury yields. That figure has bounced around in the past two years, plunging as low as 0.52% in August 2020, and as high as 3.49% in June 2022.

Since the beginning of the pandemic, mortgage rates have been on a harrowing ride, plunging as the country dipped into the coronavirus recession, then rocketing upward far more quickly than expected. Mortgage rates have added 50% to the average monthly mortgage payment since the beginning of 2022.

But there's another wild card in this new hike. With enough slowing, the country could tip into recession. There are signs the economy is slowing and may have even shrunk in the first half of the year. Many analysts say the Fed waited too long to act, losing the confidence of consumers and investors.

Recession fears often translate to lower long-term Treasury yields. If so, mortgage rates could drop again.

Another mortgage rate factor: Mortgage-backed securities (MBS). Most U.S. home loans are packaged up and sold off to investors as mortgage-backed securities, and those investors also help drive mortgage rates. The normal gap between 10-year Treasury yields and the 30-year mortgage rate is much larger than usual right now, another indicator of economic uncertainty.

With the uncertainty, investors demand greater returns on MBS, making rates even more volatile. However, if the volatility calms and the spreads return closer to normal levels, mortgage rates could actually pull back a bit.

Long story short: For those who are taking out a mortgage loan, it pays to keep an eye on rates. Stay flexible. Things can change quickly.

For home shoppers, now is also a good time for home price negotiations. From mid-2020 to mid-2022, sellers were firmly in charge of the housing market, but that reality is slowly shifting as demand tapers.