Navigating Mortgage Rates and Treasury Yield Dynamics

For investors looking to make sense of housing-related assets amidst changes in Fed policy stance, our co-heads of Securitized Product Research Jay Bacow and James Egan offer their perspective on mortgage rates and the market.

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James Egan: Welcome to Thoughts on the Market. I'm Jim Egan, co-head of Securitized Products Research at Morgan Stanley.

Jay Bacow: I'm Jay Bacow, the other co-head of Securitized Products Research at Morgan Stanley.

Today we're talking about the Fed, mortgage rates and the implications to the housing market.

It's Monday, September 15th at 11:30am in New York.

Now Jim, the Fed is meeting on Wednesday, and both our economists and the market are expecting them to cut rates in this meeting – and continue to cut rates at least probably two more times in 2025, and multiple times in 2026. We've talked a lot about the challenges and the affordability in the U.S. homeowners’ market, in the U.S. mortgage market.

Before we get into what this could help [with] the affordability challenges, how bad is that affordability right now?

James Egan: Sure. And as we've discussed on this podcast in the past, one of the biggest issues with the affordability challenges in the U.S. housing market specifically is how it's fed through to supply issues as the lock-in effect has kept homeowners with low 30-year mortgage rates from listing their homes.

But just how locked in does the market remain today? The effective rate on the outstanding mortgage market, kind of the average of the mortgages outstanding, is below 4.25 percent. The prevailing rate for 30-year mortgages today is still over 6.25 percent, so we're talking about two full percentage points, 200 basis points outta the money.

Jay Bacow: And that seems like a lot. Has it been that way in the past?

James Egan: If we look at roughly 40 years of data ending in 2022, the market was only 100 basis points outta the money for eight individual quarters. The most it was ever out of the money was 135 basis points. We have now been more than 200 basis points out of the the money for three entire years, 12 consecutive quarters. So, this is very unprecedented in the past several decades.

But Jay, our economists are calling for Fed cuts, the market's pricing in Fed cuts. How much lower is the mortgage rate going for these affordability equations?

Jay Bacow: We actually don't think that the Fed cutting rates necessarily is going to cause the mortgage rate to come down at all. And one way we can think about this is if we look at it, the Fed has already cut rates 100 basis points over the past year, and since the Fed has cut rates 100 basis points in the past year, the mortgage rate is 25 basis points higher.

James Egan: Okay, so if I'm not going to be looking at Fed funds for the path of mortgage rates going forward, I have two questions for you.

One, what part of the Treasury term structure should I be looking at? And two, you talked about the market pricing in Fed cuts from here. What is the market saying about where those rates will be in the future?

Jay Bacow: So, mortgage rates are much more sensitive to the belly of the Treasury curve. Call it the 5- and 10-year portions than Fed funds. They have a little bit of sensitivity to the third year note as well. And when we think about what the market is expecting those portions of the Treasury curve to do, I apologize, I'm going to have to nerd out. Fortunately, being a nerd comes very naturally to me.

If you look at the spread between the 5- and the 10-year portion of the treasury curve, 10 years yield about 50 basis points more than the 5-year note. So, you think about it, an investor could buy a 10-year note now. Or they could buy a 5-year note now and then another 5-year note in five years, and they should expect to get the same return if they do either one.

So, if they buy the 10-year note right now at 50 basis points above where the 5-year note is. Or they buy the 5-year note, right now, the 5-year note in five years would have to yield 100 basis points above to get the average to be the same. Well, if the 5-year note in five years is 100 basis points above where the 5-year note is right now, mortgage rates are also probably going to be higher in five years.

James Egan: Okay, so that's not helping the affordability issues. What can be done to lower mortgage rates from here?

Jay Bacow: Well, going back to my inner nerd, if you brought the 5- and 10-year Treasury yields down, that would certainly be helpful. But mortgage rates aren't just predicated on where the Treasury yields are.

There's also a risk premium on top of that. And so, if the mortgage originators can sell those loans to other investors at a tighter spread, that would also help bring the rate down. And there are things that can be done on that front. So, for instance, if the capital requirements for investors to own those mortgages go down, that would certainly be helpful.

You could try to incentivize investors in a number of different ways, that's one front. But in reality, a lot of these fees are already sort of stuck in place. So, there's only so much that can be done.

Now, Jim, let's suppose. I am wrong. I've been wrong in the past. A lot of times with you. I thought the Patriots were gonna beat the Giants in both Super Bowls. Somehow Eli Manning proved me wrong.

However, if the mortgage rate does come down, how much does it have to come down for housing activity to start picking up?

James Egan: So, this is a question we get asked roughly six to seven times a day…

Jay Bacow: How did Eli Manning beat the Patriots?

James Egan: How far mortgage rates have to come down in order to really get housing sales started again. And because of the backdrop of today's housing and mortgage markets that we laid out at the top of this podcast, it's really difficult to empirically point to a mortgage rate and calculate this is where rates have to fall to.

So, what we have been doing instead is looking at historic periods of affordability improvement, and seeing how much do we need to get that affordability ratio down to get a sustainable growth in sales volumes from here.

Jay Bacow: All right. And how much do we have to get that affordability ratio down?

James Egan: So, a sustainable increase; historically, we've needed about a 10 percent improvement in the affordability ratio…

Jay Bacow: Alright, help me out here. I think about mortgage payments as more of a function of the rate level. So, if we're in the context of like 6.25, 6.5 right now, how far does the mortgage rate need to drop to get a 10 percent improvement? Assuming that there's no change in borrower's income or home prices.

James Egan: In that world, we think you need about 100 basis point move. It would take the 30-year mortgage rate to call it, 5.5 percent.

Jay Bacow: All right, so if mortgage rates go to 5.5 percent, then we're going to immediately see housing activity pickup.

James Egan: That is not exactly what we're saying. What we've seen is the 10 percent improvement is enough to get sustainable growth in sales volumes. A year after you start to see that real improvement, the contemporaneous moves can be up, they can be down. Given what our economists are saying for the labor market going forward, what they're saying for growth in the United States, we do think you can see a little bit of contemporaneous growth.

If you start to see that 100 basis point move in mortgage rates now, we think you'll get about a 5 percent increase in purchase volumes as we move through 2026 with the potential for upward inflection in 2027 from that 5 percent growth number – again, if we get that move in mortgage rates.

Jay Bacow: Alright, so we expect the Fed to cut rates about 150 basis points over the next year and a half. It doesn't necessarily have to bring the mortgage rate down. But if the mortgage rate does go down to in the context of 5.5 percent, we should start to get a pickup in housing activity maybe the year after that.

Jim, always a pleasure talking to you.

James Egan: Pleasure talking to you too, Jay. And to all of you regularly hearing us out, thank you for listening to another episode of Thoughts on the Market.

Jay Bacow: Please leave us a review or a like wherever you get this podcast and share your Thoughts on the Market with a friend or colleague today.

James Egan: Go smash that subscribe button.