Mortgage rate relief is coming

The minutes of the July 31st FOMC meeting released today tell us it's now virtually certain that the Fed will cut rates at the September 18th FOMC meeting. The only question is by how much. The market has already priced in a cut to 5.0%, and 4.8% is not out of the question at all—the market expects the funds rate to fall 200 bps over the next 12 months. Thanks to these anticipated cuts, the 10-yr Treasury yield has fallen to 3.8%, down significantly from a high of 5.0% last October. 30-yr fixed mortgage rates—which are driven primarily by the 10-yr Treasury yield—have fallen from a high of 7.8% last October to just under 6.5% today.

But as the chart below shows, the spread between these two rates is still quite high from an historical perspective. That's due in part to the extreme volatility of 10-yr yields in the past few years. Investors need extra spread protection in this environment in order to buy mortgages, since falling yields trigger refinancings (which turn long-dated mortgage bonds into cash) and rising yields encourage homeowners to avoid refinancings (which leaves the investor saddled with a low-yielding fixed rate mortgage in a rising rate environment). When rates are relatively calm, as they were in the mid 2010s, the spread traded around 150 bps; today it is over 250 bps.

What I would expect to see is 10-yr yields settling down in a 3.5-4% range, and mortgage spreads tightening to 150 bps or less. That would put 30-yr mortgage rates at around 5-5.5%. And that would give a huge boost to the struggling housing market because it would make homes much more affordable.