Mortgage Rates — The Fed, Inflation, and COVID
Confidence seems to be growing in our nation’s ability to push through the pandemic. The Fed’s timing for slowing their purchases may be nearing, but with recent volatility in new COVID-19 cases and employment numbers, the time is not here yet. Even after any policy changes, the path of mortgage rates remains uncertain. Predictions vary widely, but given our read on the market, we expect rates to increase only modestly by the end of the year with more lift in early 2022.
- Confidence in the economy — and 2-year treasury rates — continue to fluctuate with COVID-19 and other headlines. But vaccine mandates appear to be working with new daily COVID-19 cases dropping to 66,000 over the first week of October.
- Employment in the most impacted super-sector — accommodation and food service stalled over August and September, but rapid improvement in new daily COVID-91 cases over the first half of October bring hope for renewed growth.
- Inflation numbers released last month were mixed, but focusing on two wonky measures can ease hyperinflation concerns significantly: the 5-year breakeven inflation rate is stabilizing around 2.5% and the trimmed-mean PCE, though still on the uptick, remains near target at 2.03%.
- While Fed suggests their accommodative policies could slow soon, no commitment was made to move before 2022. Economic uncertainty may lift rates moderately in fits and starts, but still solidly under 3 and a half by end of year.
Economists look at a complex web of data to understand this wily economy. However, you can gain a big dose of intuition about mortgage rates these days and into the future by focusing on three things: inflation, COVID-19 cases, and the Fed. How you think those will move over the next three months informs how you could be thinking about future rates. For example, I would expect that the jump in rates we saw over just a few days late last month, from 2.88% to 3.01% for prime borrowers, will be the largest we see until the Fed meets again in late December, but we could see a gradual, but modest, rise by the end of the year as confidence increases — say a ballpark of 3.2%.
Some quick economics first
Mortgage rates move with many things, but other government-backed loans are substitutes in the eyes of financial markets, so mortgage rates are affected by U.S. government bond yields. That’s why the Fed buys them up. Start buying U.S. treasuries (and mortgage-backed securities too) at the scale and pace they did and interest rates drop quickly. To keep them down, Fed purchases have maintained a ferocious pace. If they slow down their purchases, rates will rise.
But the Fed is not the only buyer. When confidence in the economy falls, international investors turn to bonds too, doing their part to lower mortgage rates. When confidence increases, more turn back to stock markets and mortgage rates rise.
That gives us some simple wisdom amongst a lot of randomness: while everything remains uncertain relative to the before-times, and until the Fed decides to pull back support, we’ll remain in a low rate environment. But every signal available says that economic activity will continue to improve and will lift rates. So, how confident are we about the next few months? Well, things are changing quickly.
COVID and the economy
The economy is still intimately tied to progress on vaccination rates and the pandemic behind us. Watching 2-year treasury yields move with new daily COVID cases is like a market vote on the likelihood of that success. By the time the Fed met, in late September, employment markets were feeling the last wave of the virus and cases had finally begun to level off.
And, indeed, employment in accommodation and food service fell over August as cases rose. September offered little improvement. Now seasonally adjusted employment in that heavily impacted industry is 8.7% (September jobs report) below January 2020 levels, down from 8.6% below pre-pandemic levels two month prior. Office-using industries (often the most remote friendly) remain 1.9% below.
More recent numbers on new COVID-19 cases over the past week, however, show signs of significant improvement. Perhaps vaccine mandates are working? But perhaps, also, cooler weather will undermine these improvements. The forecasts on the course of the virus change often.
Inflation risk looms
Quick! A little bit more economics: mortgage lenders have to offset higher inflation by charging higher rates or the real return on their investments will be negligible. With inflation, the dollars you earn now buy less stuff in the future. Aggressive inflation is very painful, strains general affordability, and adds uncertainty to all sorts of now-or-later type of decisions. (Sound familiar, i.e. pandemic housing markets?)
So the Fed’s mandate is to support full employment while still keeping long-run average inflation below 2.0% — meaning inflation at 2.5% for a while is acceptable. But with all the money the Fed is pouring in to the economy to lower rates, higher inflation is a real risk. So, everyone’s watching.
But it matters a lot what they’re watching. For the most part, August inflation numbers were calming. The scary headline — that the price index on an unchanging basket of goods, the Consumer Price Index (CPI), went as high as 5.28%, has come down to 5.20%. The producer price index (PCE) measure of inflation is milder at 4.26% but still spicy and faster than the previous month.
The PCE reflects the basket of goods people buy as they dodge price spikes in favor of substitutes. The trimmed mean PCE, though, is my favorite. A better reflection of core inflation during these times of violent, but transitory, pandemic supply shocks, it trims out the products with the most volatile prices. That measure did rise slightly over August but remains near target at 2.03%.
If we want to look at the market’s vote on inflation over the next five years, that would be the 5-year breakeven rate. That measure has stabilized around 2.5%, practically unchanged over September.
We could stay at 2.5% for a bit without the average long-run inflation rate lifting above 2%. We did it for over five years in the aughts and have been pretty much under since.
The Fed
With the uncertainty introduced by the recent Delta variant surge and continued comfort with August inflation numbers, the Fed has announced that it can keep holding the line — buying up treasuries and mortgage-backed securities at their established pace to keep interest rates low until we’ve made even more progress. If new COVID-19 cases continue to drop, and employment turns back around, we could make that much progress soon.
The Fed’s lack of urgency was a surprising bit of good news to the investment community, since appreciation in national home prices hit a shocking pace this season, leading to speculation the Fed would move sooner. That good news of continued support caused a flush of economic confidence and pushed rates for prime borrowers briefly back up above 3%.
While it seems certain higher rates are around the corner, it feels important to emphasize how uncertain the next few months will be. Because the massive, expansionary monetary support has delayed or obscured many financial markets’ responses to the pandemic. Removing that support will add its own uncertainty. So, you can be sure that it will be done carefully.
As confidence rises in the economy, the demand for longer t-bills wanes, lowering their prices and the implied yields. Mortgage rates move with those yields too. That gives us some simple wisdom: while everything remains uncertain relative to the before time we’ll remain in a low rate environment, but every signal that economic activity will continue to grow will lift rates.
So how confident are we? The economy is still intimately tied to our progress getting enough of us vaccinated and the pandemic behind us. Watching 2-year treasury yields is like watching the markets vote on the likelihood of that success.
That vote popped after the Fed announced at the FOMC meetings last week that they’ll continue to support investment (and buy MBS and U.S. bonds to keep rates low) despite the craziness in the housing market. The rise in COVID cases is too much of a concern and inflation worries are too overblown. And indeed employment in accommodation and food service fell over August. Now it’s 8.8% below January 2020 levels, down from 8.6% below pre-pandemic levels in July. Well from the perspective of assets
