Michael Brush at MarketWatch presents a compelling argument on the future trajectory of mortgage rates, even in the face of sustained higher inflation. Brush explains that mortgage rates are fundamentally linked to the 10-year Treasury yield, “Mortgage rates are priced off of the 10-year Treasury yield plus a risk premium. One of the big reasons why lenders charge a premium is to offset prepayment risk.”
The Spread: Typically, the spread between mortgage rates and the 10-year Treasury yield hovers around 1.5 to 1.75 percentage points. However, volatility in inflation and the economy has inflated that premium.
- Brush notes, “The typical spread between mortgage rates and the 10-year Treasury yield is about 1.5 to 1.75 percentage points. Recently this spread hovered around 2.75 percentage points.”
Stability: Brush suggests that even if inflation remains elevated, mortgage rates could still fall, provided certain conditions are met. If inflation and the Federal Reserve’s actions become more predictable, the risk premium demanded by lenders would decrease. This is because a stable and predictable economic environment reduces the likelihood of prepayment risk.
Soft-Landing: Moreover, if Federal Reserve Chair Jerome Powell succeeds in achieving a “soft landing”—wherein the economy slows enough to curb inflation without triggering a severe recession—the necessity for drastic rate reductions would diminish. This stability would further reduce the risk premium.
Rates: Should the premium spreads return to their historical norms, current mortgage rates could drop to around 6.0%, potentially even reaching the high 5.0% range. This adjustment would be a significant relief for borrowers and could stimulate the housing market.
Bottom Line: While higher inflation typically leads to higher interest rates, a stable and predictable economic environment can mitigate the risk premium, thereby lowering mortgage rates. If the Federal Reserve’s policies manage to stabilize the market without drastic rate cuts, we could see a normalization of mortgage rates even amid persistent inflation.
