There was no rest for weary rate watchers after last week’s rout. This week proved to be even more volatile.
UK in the spotlight (again)
British problems still have a big impact. Last week’s rate spike was more easily attributed to market panic over a UK budget decision. The panic remained on Monday and escalated on Tuesday.
Why should the United States care? Global financial markets are interconnected in many ways. Even though something happening in the UK will have more of an effect on UK markets, if the effect is big enough it is felt around the world.
The drama of the past two weeks has been more than enough. Additionally, the UK and US bond markets (the markets that determine interest rates) are more correlated than most. Here is an updated chart showing the relative movement of each country’s 10-year sovereign debt (higher yields = higher rates):
In other words, they took a sad song and made it worse. It was a very serious episode for the global financial markets and especially for the UK. Markets were expecting some sort of official intervention on Tuesday, when it didn’t happen, rates saw their biggest rise.
Then on Wednesday, the Bank of England (BOE) stepped in to appease markets with an emergency bond purchase announcement. While this did not undo all the damage that had been done, it did at least stem the tide of rising rates. Here’s a different visualization of US and UK 10-year bonds, this time with separate y-axes, just to show the correlation in motion.
It’s unclear whether we’ve seen the latest fallout from UK fiscal policy, but the BOE’s emergency announcement means the next response is unlikely to be as volatile.
It’s not all about the UK
As dramatic as one episode may have been, it wasn’t just about the UK. Major central banks typically adopt policies that push rates higher in the name of fighting inflation. The news from the UK wouldn’t have hit so hard if rates hadn’t already risen so much around the world and markets weren’t already jittery about inflation and associated policy responses.
The Fed is at the forefront of rate hike policy. This refers not only to the rise in the real fed funds rate, but also to the decrease in the amount of bonds on the Fed’s balance sheet, which puts additional upward pressure on long-term rates like mortgages. . When this rate backdrop combined with UK-induced volatility this week, it caused big problems for US mortgage rates.
All about mortgage rates
The average 30-year fixed rate rose above 7% on Tuesday. Many lenders were still able to offer rates within 6, but this required “points” (a percentage of the loan balance paid up front in order to obtain a lower rate than would otherwise have been available) . Taking into account the points, even the highest rated lenders exceeded 7%.
But only a handful of forward-thinking lenders were able to offer viable rates above 7%. The ability to do so depended on the ultimate source of funds for the loans — the investor, to use industry terms. In the case of large banks and credit unions, the investor may be the bank itself. In other cases, the investor is the free market, and generally the free market has been quite reluctant to pay a premium for higher rates.
What is the mortgage rate “premium”?
Normally, a mortgage borrower can opt for a higher rate in exchange for lower upfront costs (or even lender credit). This is called “premium” pricing because investors typically pay a premium for a higher rate of return. This premium can then be used to cover initial loan costs.
Premium pricing has been non-existent at times in 2022, and the well has almost completely dried up in the past 2 weeks. There are several reasons for the lack of premium. The simplest is that lenders don’t want to rely on higher interest over time to reap their profits if the risks are higher than borrowers will refinance at the first sign of falling rates.
The convoluted reason is complex enough to avoid discussing it in detail, but it has to do with how quickly financial markets are changing and the fact that the mortgage-backed securities needed to facilitate premium pricing don’t exist. simply not in the quantities required to create a healthy and liquid market. This lack of investor participation in the premium pricing realm means that lenders can actually offer you much better terms if you pay points.
Here’s the starkest example of no premium pricing: for many lenders this week, they would make more money giving you a loan at 6.625% versus 7.625%.
Wait what?! Don’t lenders want higher rates of return? !
They absolutely do, and indeed some lenders with their own money to lend are happy to offer the highest rate. Other lenders have to consider what investors are actually paying to acquire these higher rate loans, and in many cases this week it was about the same for a 6.625% or 7.625%.
What’s next for pricing?
On a note specific to mortgages, if market volatility abates and rates manage to stay sideways, premium prices will gradually return. In fact, this was already happening in several notable ways by the end of the week.
As for rates in general, what happens next depends on inflation and the economy. The Fed is afraid of moving too quickly to a less hostile stance because of lessons from the past. He concluded that he would rather make the mistake of hurting the economy too much than not doing enough to fight inflation.
As such, economic data is essential. Strong data will only embolden the Fed’s stance and put upward pressure on rates. Sufficiently weak economic data, seen in several reports for a few successive months, will get the Fed’s attention. In fact, that’s their goal. They WANT to see the economic pain because they believe it will help inflation fall back into its target range. Assuming the pain translates into lower inflation, the Fed will pause to reconsider its policies, but that will take several months at the bare minimum, and if we take the Fed at its word, it would take more than a year. before it considers cutting rates. .
In the meantime, clues can come in pieces, especially from the most important economic reports. The week ahead counts several with ISM PMIs on Monday and Wednesday. Then on Friday we have the next installment of the all-important jobs report – one of the only economic reports capable of challenging the consumer price index (CPI) in terms of potential market movement. Incidentally, CPI is released the following week (Thursday 10/14).
What’s next for housing?
In the meantime, the housing market is suffering. As long as this pain is measured and not too disruptive to the financial market, the Fed actually prefers it!
Whether or not the changes were “measured” is debatable. Admittedly, if we use the peak of the recent housing and mortgage boom as a benchmark, the reversal was extremely sharp. This is even the case for house prices, which normally lag further behind rate hike cycles.
In new July figures released this week, the two major house price indexes posted the biggest month-over-month declines since the Great Financial Crisis.
But if we take a step back and look at the data in annual terms, it does indeed seem more measured.
The catch is that the annual appreciation will certainly continue to decline in this rate environment. We cannot be sure how much it will decrease. It’s certainly possible it could move into negative territory, but if it does, it’s important to understand that the powder barrel of ingredients responsible for our current situation is very different from the 2008 example. In other words, in 2008 the housing and mortgage markets CAUSED the downturn, a fact that markets and consumers were slow to forget in subsequent years. In this case, the housing and mortgage markets are in an infinitely better position to emerge strong from the economic downturn that the Fed is determined to deliver.