Can Fed Cuts Bring Mortgage Rates Down?

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.

Read more insights from Morgan Stanley.

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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 cert