Prospective homeowners are facing a challenging market characterized by high prices, limited inventory, and rising mortgage rates. However, a glimmer of hope may lie in a measure known as the mortgage spread, which has been declining recently after several years of elevated levels. If this trend continues, it could lead to lower mortgage rates in the coming months, although a complete normalization is unlikely.
Understanding Mortgage Spreads
Mortgage spreads refer to the difference between the average rate of a 30-year fixed mortgage and the yields of 10-year Treasury bonds. Several factors influence this spread, including a homebuyer’s creditworthiness, the broader economic environment, and Wall Street’s demand for mortgage-backed securities.
Historically, the average spread has been around 1.8 percentage points. This means if 10-year Treasury yields are at 4%, mortgage rates typically hover around 5.8%. However, starting in 2022, spreads began to rise significantly, peaking at over 3 percentage points. Consequently, at the same Treasury yield, mortgage rates surged to approximately 7%.
Recent Trends
Currently, mortgage spreads have eased to about 2.25 percentage points. Laurie Goodman, founder of the Housing Finance Policy Center at the Urban Institute, noted that while wider spreads have worsened mortgage affordability, they are expected to narrow. However, she cautions that spreads may not return to historical norms.
Spreads tend to widen during financial downturns as investors prioritize safer securities. The widening observed in 2022 was unusual, as the economy remained relatively strong. The primary catalyst for this increase was the Federal Reserve’s withdrawal from the mortgage market.
The Federal Reserve’s Role
Following the 2008 financial crisis, the Fed purchased substantial amounts of mortgage-backed securities to stimulate the economy and promote lending. This practice continued during the pandemic. However, in 2022, the Fed halted these purchases to combat inflation and began to reduce its holdings by allowing bonds to mature without reinvesting.
This exit left a significant gap in the mortgage market. Christopher Maloney, a mortgage strategist at BOK Financial, highlighted the absence of a “buyer of last resort” as a key factor keeping spreads elevated.
Current Market Dynamics
In addition to the Fed’s withdrawal, heightened market volatility and uncertainty about future interest rate movements have also contributed to wider spreads. The surge in refinancing activity during 2020 and 2021, when rates were exceptionally low, led to faster-than-expected payouts for mortgage bonds, prompting investors to demand higher spreads.
While the Fed is not expected to return to the mortgage market soon, conditions that have kept spreads high are beginning to improve. Rob Haworth, a senior investment strategist at U.S. Bank’s asset management group, noted that market consensus around future Fed rate cuts is emerging, with expectations that rates will gradually decline.
As the market continues to stabilize, many industry experts anticipate a movement toward more normalized mortgage rates, offering a potential reprieve for homebuyers navigating a challenging landscape.
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