Key to lowering interest rates

One Thing That Could Ease Mortgage Rates

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On the heels of one of the fastest mortgage rate upticks ever, you’re probably wondering what’s next? There is one fairly probable scenario where rates ease back a bit.

What Pushed Mortgage Rates Up in 2022?

One popular yet not totally accurate answer to why mortgage rates increased in 2022 is “the Fed increased rates”. The answer misses the mark simply because the Fed doesn’t directly move mortgage rates. However, the reason for FOMC rate increases often mirrors what’s behind mortgage rates moving higher.

The topical reason in common between FOMC rate decisions and mortgage rate movement is Inflation. Think of inflation like summer heat. Summer heat encourages homeowner’s to turn the air conditioning up to cool things down. Much like inflation causes the Fed to increase the Fed Funds Rate to cool down inflation.

Additionally, summer swelter causes families to avoid outdoor parks and stay inside. Much like heat lowers the demand for outdoor family activities, inflation reduces demand for mortgage bonds driving mortgage rates up.

Two separate functions (FOMC rate decisions & mortgage rate movement) caused by the same stimulus (inflation).

Why Does Inflation Push Mortgage Rates Up?

To understand this first understand what financial instrument directly moves fixed mortgage rates up and down. That instrument is a mortgage bond. Bonds are long term guaranteed fixed low rate of return investments. You’ll also want this next tidbit for later in the article:

  • A decrease in mortgage bond price = an increase in mortgage rates
  • An increase in mortgage bond price = a decrease in mortgage rates

Now, what happens to the future buying power of money parked in fixed/low rate of return bonds during high inflation? The more inflation rises, the less buying power each dollar locked in a bond has.

For example, assume a bond’s rate of return is 4% per year. At the same time, assume the cost for a gallon of milk climbs 8.6% per year. In this case, money invested in the 4% bond loses buying power over time. Goods and services 8.6% cost increase outpaces the bond’s 4% return therefore the amount of goods and services the invested bond money can buy in the future decreases.

When bond’s rates of return fall well below inflation, investing in bonds becomes much less attractive. The end result – the demand and price for mortgage bonds decrease. Therefore, mortgage rates increase (see tidbit above).

What Could Make Rates Come Down?

While a multitude of factors influence mortgage rates, one very conceivable way back to “eased” mortgage rates is lower inflation. In other words, the price of goods and services still rises but at a much lower pace – 2% to 3% per year.

When inflation heads south convincingly approaching normal levels mortgage rates should ease. Falling inflation eventually creates an increased demand for mortgage bonds (and that’s good for mortgage rates). For example, assume a mortgage bond pays 4% while a gallon of milk’s cost rises just 2% per year. In this case, buying power increases over time for money invested in the 4% bond.

Bonds beating the pace of inflation revitalizes demand in bonds at some point – or at least it should theoretically. We all know when demand for something increases it’s price soon follows. In this story, what’s important is that when lower inflation arrives, mortgage bond prices should increase which decreases mortgage rates (see tidbit above).