Waiting for Mortgage Rates to Fall? Don’t Hold Your Breath.

I bought an apartment last year and if I were buying today, I wouldn’t be able to afford it. The increase in mortgage rates would mean $1,000 more a month than I am paying now. It may be the only time in my life I (inadvertently) timed the market right.

Now, my friends who want to buy are waiting and hoping for those heady 2.7% 30-year fixed mortgage rate days to return. Some are betting they will and taking out an adjustable rate mortgage. But rates may never go back down, at least not that low. Rates might even go higher; we may come to pine for the days of a 5% mortgage rate. For most of the 1980s mortgage rates were more than 10%.

The low rates of the last few years were an anomaly, a combination of freakishly low interest rates and Federal Reserve intervention in the bond and mortgage-backed security market. Now the Fed has ended quantitative easing and is raising rates. But what really matters is what happens to the 10-year bond yield, because that determines mortgage rates. And like mortgage rates, the 10-year bond yield has been rising recently, hovering just under 3% at last count. But this yield is also still low, by historical standards.

Until very recently, many financial macro economists would put their money (if they made active market bets—which they don’t) on the 10-year rising. The finance literature assumed bond prices mean-revert, or they may bounce around for a few (or several) years, but over the long term they’ll revert to a historic average that reflects how much people want to save versus spend — with the idea that the desire to save should be fairly stable over time. Also, unlike stocks, bond prices can’t keep going up, otherwise we would end up with very negative yields; few investors would accept a -10% yield. So ever since the 1990s, the mean-reverting faithful have been waiting for the 10-year bond yield to return to its historic average of about 6% to 7%.

We are still waiting. After nearly 40 years of declining yields, our faith has been tested. If the 10-year does mean revert, it is reverting to much lower yields. There are good reasons to think the 10-year will never return to 1980s levels, so mortgage rates aren’t likely to rise that high, either.

Contrary to conventional wisdom, Fed policy doesn’t have much impact on the long-term bond market (though quantitative easing may be an exception). Most of the time, long-term bond yields are a function of three factors. The primary one is simply the supply and demand for bonds. The mean-reversion believers assumed demand for bonds was fairly stable, but then it increased — a lot. Foreign governments and investors, looking to stabilize their currency and transact in dollars, developed an insatiable appetite for dollar assets.

Meanwhile regulation required financial institutions to hold more bonds. The Fed also became a big buyer; its new policy playbook involves buying long-duration assets when there’s a hiccup in the economy that threatens market liquidity. The Fed may have put an implicit price floor under the stock market, but the last two recessions made it plain there is an explicit floor under bond prices, and this makes them more valuable and drives down yields.

The other two factors have to do with inflation. If you hold a 10-year bond to maturity you’ll want to be compensated for the inflation that will occur over that time. We don’t know what inflation will be over the next 10 years, but bond holders bear that risk, so the more unpredictable inflation is, the higher yields go. When inflation became both much lower and more predictable — as we saw in the decades before the pandemic — bond yields trended down.

Whether yields (and mortgages) go up or down or stay the same depends on whether these three factors change again. And there are reasons to think the 40-year bull treasury market is over. Foreign governments and investors are losing interest in US treasuries. Inflation may be permanently higher and more uncertain.

However, not all hope is lost. Fed policy and financial regulation probably won’t change, and that will support demand. So on balance, mortgage rates may go up further, but they probably won’t reach 1980s levels — unless inflation spikes again and sticks around. Then, anything can happen.

All of this suggests that you can’t time the market or the future of interest rates. If you are waiting for rates to fall, you may be waiting for a long time.

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