Jim Iuorio, for CME Group
At a Glance:
- The spread between 30-year mortgages and 10-year yields typically fluctuates between 100 and 300 basis points.
- In January, CME Group introduced a new tool for hedging rate risks: Mortgage Rate futures.
As the housing market continues to navigate challenging conditions, many borrowers are pinning their hopes on the Federal Reserve’s easing cycle to bring down mortgage rates. However, the reality is not so straightforward.
Thirty-year fixed mortgage rates are closely tied to the U.S. 10-year Treasury yield, and this connection exists because the average homeowner typically holds their mortgage for about 12 years before refinancing, prepaying or moving. Despite the 30-year term of the mortgage, the 10-year yield remains the more relevant benchmark.
Assessing Trends
Typically, when the Federal Reserve begins lowering short-term rates, longer-term rates follow suit. However, this pattern hasn’t held true in the current cycle. Since the Fed began lowering rates on September 18, 10-year yields have actually risen from 3.7% to a high of 4.8% on January 13th.
Most analysts attribute this anomaly to rising inflation expectations and the Treasury’s growing need to issue longer-duration bonds to service the national debt. Some also suggest that the prevailing economic environment favored risk assets over the safety of Treasury bonds, further dampening demand. This unexpected trend highlights the complex interplay between monetary policy and market dynamics, making it clear that the path to lower mortgage rates is far from guaranteed.
According to data from Yahoo Finance, the average 30-year mortgage rate typically runs about 180 basis points above the U.S. Treasury 10-year yield. For instance, a 10-year yield of 4.5% would typically correspond to a 30-year mortgage rate around 6.30%.
However, this spread isn’t fixed and can fluctuate between 100 and 300 basis points depending on various factors. Two main components make up the spread between 30-year mortgages and 10-year yields.
The first, named the ‘primary-secondary’ spread, covers the difference between where mortgages are originated (in the primary market) and the yields on mortgage-backed securities (in the secondary market). This difference covers industry origination costs, servicing fees and guarantee fees. This spread averaged 50 basis points before the 2008 financial crisis but expanded to around 100 basis points afterward, largely due to new regulatory requirements.
The second component, the ‘secondary spread,’ represents the additional risks of investing in mortgages versus Treasury yields. Prepayment risk, or the risk that a borrower will pay back a loan before its maturity, is often a primary consideration. Economic uncertainty typically widens this spread. During the 2008 financial crisis, it peaked at almost 200 basis points, pushing the total spread to a historic high of 296 basis points, according to Fannie Mae data.
Spread Remains High
Over the past year, despite a robust economy, the total spread has averaged an unusually high 249 basis points. This could indicate either caution about the current economic expansion or simply reflect that Treasury yields are high enough to make investors hesitant about taking on additional mortgage risk. Interestingly, this cautious sentiment isn’t reflected in corporate credit spreads, which remain at historic lows.
Why would one market signal low risk while another suggests high risk?
The disparity might indicate that markets expect any upcoming economic stress to impact residential real estate more directly than other sectors. The secondary spread data supports this theory, averaging 140 basis points between August 2022 and November 2024, nearly double the 71 basis point average seen from August 2012 to 2019, according to Fannie Mae.
The direction of 10-year yields remains the primary driver of mortgage rates, particularly in the current high-rate environment where the Treasury yield comprises approximately 65% of the mortgage rate.
Watching Inflation
What could drive 10-year yields lower? While numerous factors affect the supply-demand dynamics, inflation expectations top the list. The February 12 CPI uptick to 3.0% has justifiably raised concerns about inflation resurgence. Inflation makes fixed-rate, long-duration bonds less attractive as repayment occurs in devalued currency. Reduced bond demand means higher rates, especially when the U.S. Treasury must issue enough bonds to cover projected 2025 debt service exceeding a trillion dollars. The counterbalance would be a disinflationary environment, potentially driven by productivity advances or significant reductions in government spending, decreasing bond supply.
As these dynamics evolve, market participants have a new tool from CME Group to manage uncertainty in the mortgage market. Based on the Optimal Blue Mortgage Market Index, which tracks real-time rate lock data from over one-third of U.S. residential mortgage originations, Mortgage Rate futures offer a way to hedge mortgage servicing rights and pipeline risk that can be associated with a changing rate environment.
With many unknowns still ahead, inflation, along with economic strength and monetary policy will remain important areas to monitor.
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