Mortgage interest rates could decline in 2023. How is it feasible?
The cost of obtaining a mortgage has more than doubled over the course of 2022, resulting in a precipitous decline in both accessibility and demand in the property market. We see a correction in the property market because decreased demand usually results in decreased pricing. It is my perception that the quickly increasing interest rates on mortgages are the primary cause of this correction and that it will continue for as long as rates remain at their current levels. Therefore, the question that has to be asked is, what do you think will happen to mortgage rates in the following year?
Many people are predicting more mortgage rate increases due to the Federal Reserve’s announcement last week that it will increase the Federal Funds Rate (FFR) by an additional 75 basis points. The Federal Reserve has indicated that it plans to continue increasing the FFR for the remainder of this year and at least into the beginning of the year. Since this is the scenario, many people have increased their 2023 mortgage rate predictions to 8% (from an average of roughly 7.1% at the time of writing).
However, many renowned analysts predict that mortgage rates will decline in 2023. In 2023, rates are forecast to plateau at roughly 5.4%, according to the Mortgage Bankers Association. Mark Zandi, an economist, anticipates a little reduction in interest rates, bringing them to 6.5%. According to Rick Sharga of ATTOM data, interest rates are expected to reach a high of about 8% before declining to below 6% by the end of 2023. In the next year, Logan Motashami believes mortgage interest rates may decline.
What’s the deal with that? How could interest rates go down if the Fed has already indicated that they want to raise them, and the economy is in such a precarious state? I am conscious that this looks ridiculous, but this prediction is based on economic logic, and thus we need to investigate it.
The Federal Reserve does not have direct control over mortgage rates
First, it’s important to keep in mind that the Fed doesn’t set mortgage rates. When the Federal Reserve talks about “raising rates,” they are referring to the Federal Funds Rate (FFR), which influences mortgage rates but does not directly regulate them (or credit cards, car loans, etc.). On the other hand, mortgage rates are directly influenced by the yield on the 10-year Treasury bond, despite the fact that the Fed only has a limited, indirect influence on these rates.
I performed an analysis to determine the degree of connection between the yield on the bond and mortgage rates, and the result was astounding.99. However, mathematical calculations are not required in order for you to comprehend this. The following figure demonstrates that mortgage rates and the yield on a 10-year bond move in the same direction.
Mortgage rates and the yield on the 10-year Treasury note fluctuated in tandem because of how banks generate revenue and manage their business’s risk and reward profile. Imagine that you are a financial institution with access to billions of dollars it can lend out. Every day, you have to choose whom you should lend your money to, how risky each possible loan is, and how much profit you need to make (in the form of an interest rate) to compensate for the risk. The higher the perceived level of risk associated with a loan by the lending institution, the higher the interest rate will be on that loan.
Lending money to the United States government as a bond is considered the least risky type of financing available anywhere in the world (called a Treasury Bill). A loan to the United States government is what a Treasury Bill ultimately amounts to. Furthermore, the risk involved is very small because the United States government has never been in default on any of its commitments. Because the United States has always fulfilled its bond obligations, holding U.S. bonds presents a very low level of risk for any kind of investor, whether financial institutions or individuals.
An investment in 10-year Treasury securities now yields about 4%. Therefore, a bank has the potential to earn an interest rate of 4% with almost no risk. However, banks want returns greater than 4%, so in addition to purchasing treasuries and lending to the U.S. government, they provide credit to companies and people, often in the form of mortgages.
In the big scope of things, mortgages don’t pose much danger, yet everybody who takes out a mortgage has less creditworthiness than the United States government. The bank is taking on greater risk by providing mortgage financing than it would be providing the same funds to the federal government. Therefore, the bank will charge you a higher interest rate to account for the extra risk it is taking by extending credit to you. When it comes to a 30-year fixed-rate mortgage, financial institutions often charge an additional 170 basis points (one basis point is equivalent to 0.01, so 170 basis points are 1.7%) on top of the yield on a 10-year Treasury bond.
How Might Mortgage Rates Fall in 2023?
The two competing theories are:
First, there is a potential that bond yields will go down, which would, in turn, cause mortgage rates to go down. There is widespread agreement among economists that a worldwide recession will begin in the year 2023. Shareholders tend to search for low-risk assets during a recession, and as we’ve shown, the investment with the least amount of risk everywhere in the world is a U.S. Treasury bill. Because of the inverse relationship between bond prices and yields, the demand for United States Treasuries may lead bond prices to increase (more demand = higher prices), which in turn may force yields to decrease.
Therefore, the primary reason why mortgage rates might decrease in 2023 is that we could experience a worldwide recession. This would increase the demand for United States Treasuries, pushing bond yields and mortgage rates down.
The existing disparity between yields and mortgage rates is another factor that might lead to a decline in mortgage rates in 2023. Do you remember what I stated earlier about how financial institutions add the premium to the bond yields of mortgage borrowers owing to the higher level of risk involved and how this additional premium is typically 170 basis points? However, at the moment, that premium comes in at 292 basis points, 72% more than the typical spread!
The gap can widen when there is a great deal of economic unpredictability. Just have a look at the graph down below. Only on three occasions since 2000 has the spread been considerably higher than 200 basis points; those instances were during the Great Recession, the start of the pandemic, and presently. The current spread is a new all-time high not seen since 1986.
We are currently uncertain; nevertheless, it is conceivable that things will become clearer in 2023 (let us hope). I expect a decrease in the disparity between the 10-year yield and mortgage rates if inflation moderates and the Fed slows or reverses its rate rises, which may lead to lower mortgage rates even if yields remain high.
It is essential to clearly understand that there is a realistic potential for mortgage interest rates to decline in 2023, although we do not know what will transpire.
When asked about the issue, Nadia Evangelou, the Senior Economist and Director of Real Estate Research for the National Association of Realtors provided an excellent synopsis by stating that there are three potential outcomes in the year 2023. “In case number one, the rate of inflation continues to be rather high, which compels the Federal Reserve to keep increasing interest rates. This indicates that mortgage rates will continue to increase, and there is a potential that they may approach 8.5 percent. If the consumer price index shows a greater response to the Fed’s rate rises and inflation gradually decelerates, then mortgage rates will likely settle in the 7% to 7.50% range by 2023 (Scenario 2). In the third possible outcome, the Federal Reserve increases interest rates on many occasions to bring down inflation, which leads to a contraction in economic activity. Because of this, rates can go down to 5%.
What you are saying makes perfect sense to me. This indicates that we will have to wait and watch what happens with inflation to determine the path mortgage rates (and maybe property prices) take in the next year.