Why Mortgage Rates are Elevated Despite Fed Rate Cuts

Mortgage borrowers and investors often assume that when the Federal Reserve lowers its target for the federal funds rate, mortgage rates will follow in lockstep. This is generally true when both short and long-term interest rates are falling in tandem.

More recently, as the Wall Street Journal pointed out - mortgage rates have held steady or even risen slightly as the Fed has lowered its short-term rate.

With recent federal rate cuts and the expectation for more to come, short-term interest rate dips have outpaced long-term rate adjustments, tempering the expectation of lower mortgage rates.

Mortgage rates shift on a broader range of influences - not just Fed rate adjustments.

Factors like long-term Treasury yields, credit spreads, the risks of borrowers paying off their loans more or less quickly than expected, and market expectations for inflation and economic growth can redefine what it looks like for investors like Dynex to assess the riskiness of lending at a fixed rate for a 30-year term.

So, how do we bridge the gap between market expectations and fed rate activity? Let’s explore why these dynamics don’t always align, what other factors matter, and why the shape of the yield curve matters for mortgage-backed securities (MBS).

A line chart titled "Mortgage rates high despite Fed cuts" shows the Fed Funds Target Rate from July 1990 to May 2023. The chart indicates a general decline in rates from the early 1990s to the mid-2010s, followed by a sharp increase beginning around 2022. Despite recent Federal Reserve rate cuts, mortgage rates remain elevated. The x-axis represents time, and the y-axis represents the Fed Funds Target Rate, ranging from 0% to 11%.

Why Don't Mortgage Rates Follow the Fed Funds Rate?

The federal funds rate is a short-term interest rate that banks charge one another for overnight loans. Mortgage rates, on the other hand, are long-term rates that depend more on movements in the 5-year and 10-year Treasury yields. Here’s why:

1. Different Time Horizons:

The Fed funds rate primarily affects short-term rates, while mortgage rates are tied to longer-term rates that reflect investors’ expectations for inflation, economic growth, fiscal policy, and future Fed policy.

2. Risk Premiums:

Mortgage rates include risk premiums to compensate for prepayment risk (the risk that borrowers repay early) and credit risk (the risk that borrowers default). These premiums are not tied to the Fed’s rate decisions - they reflect the inherent risk in the actual mortgage cash flow.

3. Market Sentiment:

If investors expect inflation to rise or economic growth to accelerate, or fiscal policy to be funded with long-term debt issuance, long-term Treasury yields—and consequently mortgage rates—may rise even if the Fed is cutting rates. The market just experienced a similar scenario, which has played a significant role in mortgage outlooks.

Yield Curve historically steepens when the Fed cuts rates

When the Fed adjusts rates, remember to look beyond the headlines and consider the broader yield environment.

The yield curve is the spread between interest rates on longer-term and shorter-term debt. Historically, the yield curve gets steeper when the Federal Reserve cuts rates because short-term rates fall faster than long-term rates.

A line chart titled "Yield Curve typically steepens as Fed cuts rates" shows the relationship between the Fed Funds Target Rate (in dark blue) and the Yield Curve Spread (10-year UST yield minus 2-year UST yield, in green) from July 1990 to May 2023. The chart suggests that the yield curve spread tends to rise (steepen) when the Fed cuts interest rates. The x-axis represents time, while the left y-axis shows the Fed Funds Rate (0 to 8), and the right y-axis shows the yield curve spread (-1.00 to 3.00). Periods of rate cuts align with increases in the yield curve spread. — source: Federal Reserve Bank of St. Louis FRED, The Bloomberg Professional Service.

Lower Fed funds rates reduce banks' and Dynex's short-term borrowing costs. Amid the steeper yield curve that typically results, banks have an incentive to invest in longer-term assets, such as MBS.

MBS become a preferred choice for banks seeking safe, liquid, and yield-generating investments.
Agency MBS, backed by government-sponsored enterprises, are particularly attractive due to their strong credit quality.

At Dynex Capital, we actively monitor these factors to manage our portfolio and create value for our shareholders. The investment environment is attractive when our financing costs are falling faster than the yields on our investments. We are experts at extracting these types of spreads and by staying attuned to the nuances of rate movements and yield curves, we can capitalize on emerging opportunities. Private capital like ours can help keep mortgage rates in check by buying MBS.

Stay tuned for more insights in future editions of The Dynex Angle, where we decode market trends and share perspectives to empower your investment journey.