The Fed cut rates. Why are mortgage rates rising?

The Federal Reserve cut rates by 50 basis points, and long-term borrowing costs promptly went up. The ten-year Treasury yield rose from 3.62 per cent to more than 4.0 per cent, pushing thirty-year fixed mortgage rates back towards seven per cent. Few market moves in recent years have looked so perverse.

Bond buyers want more

Homebuyers and equity investors who expected cheaper money were left puzzled. The answer lies in the yield curve. By cutting while the economy was still growing well, the Fed stoked inflation expectations and lent weight to the case for higher nominal growth. Holders of long bonds asked for more yield to cover future inflation and the steady flow of new federal debt. Easing at the short end simply steepened the curve.

What a ten-year yield is made of

A ten-year yield can be split into two parts. The first is the average overnight rate investors expect over the life of the bond. The second is the term premium, the extra return they demand for locking money away for a decade rather than rolling over short-term bills. The Fed controls today's overnight rate directly, and influences expectations through its projections, but it has little direct say over the term premium.

The low of 3.62 per cent came in mid-September, when markets had priced a long and deep easing cycle. Since then two things have happened. Strong economic data, above all September's payroll report, have made investors doubt that the Fed will cut as far as they assumed, raising the expected path of short rates. And the premium for holding duration has crept up as investors weigh inflation risk against a heavy supply of new Treasuries.

From Treasuries to mortgages

American mortgage rates are priced off the ten-year yield, not the Fed's policy rate, because most home loans are refinanced or repaid well before their thirty-year term expires. Lenders add a spread to cover the risk that borrowers refinance when rates fall, the cost of funding and servicing, and the appetite of investors in mortgage-backed securities. That spread has been unusually wide since 2022, partly because the Fed stopped buying mortgage bonds and began letting its holdings run off, removing the largest buyer from the market.

The effect is that a half-point fall in the policy rate can coincide with a rise in mortgage costs. Refinancing applications had picked up in September as rates dipped; that brief window is now closing, and lenders who staffed up for a refinancing revival will have to wait for it. Homebuilders, which have been offering to buy down mortgage rates for their customers to keep sales moving, face higher costs for doing so.

What the Fed could do about it

The central bank does have tools aimed at the long end, though it is reluctant to use them. It could stop shrinking its balance sheet, or resume buying mortgage bonds, which would narrow the spread between mortgage rates and Treasuries. It has already slowed the pace at which it lets Treasuries mature without replacement, cutting the monthly cap from $60 billion to $25 billion in June. Mortgage bonds, however, are still being allowed to run off, and officials have said they want a balance sheet made up mainly of Treasuries in the long run. Buying mortgage bonds again with inflation above target and the economy growing would be hard to justify, and nobody expects it.

This has happened before

The disconnect is not new. In 2004 and 2005 Alan Greenspan raised short-term rates steadily while long yields fell, a puzzle he called a conundrum. The present episode is the mirror image. After the Fed's insurance cuts in 1998, long yields also rose through the following year as the economy stayed strong and the Fed eventually reversed course. In both cases the bond market judged the outlook for growth and inflation on its own terms rather than taking its cue from the central bank.

Who is caught out

The losers are would-be buyers and sellers of homes. Millions of homeowners locked in mortgages below four per cent during 2020 and 2021 and have little reason to move and take on a loan at a far higher rate, which keeps the supply of existing homes thin and prices high. First-time buyers face both high prices and high borrowing costs. Borrowers with floating-rate debt tied to short-term rates, by contrast, do benefit from the Fed's cut, as do banks, whose margins widen when the curve steepens.

The Treasury also pays more. Every rise in long yields raises the cost of refinancing a debt stock that grows by well over a trillion dollars a year, and neither presidential candidate has offered a credible plan to narrow the deficit. That fiscal backdrop is one reason investors may keep demanding a higher term premium whoever wins in November.

The case that this is good news

There is a more benign reading. Much of the rise in yields followed data showing that the economy is stronger than feared, which means investors expect fewer cuts because fewer are needed. Market measures of long-term inflation expectations have moved only modestly. A rise in yields driven by growth is a sign of health, and it is very different from a buyers' strike against American debt.

That reading is largely right, and it does not rescue the homebuyer. Whether long yields rose because of growth, inflation risk or supply, the lesson is the same: the Fed's cuts do not travel automatically down the curve. The consumer price index due later this week and the Treasury's next quarterly refunding announcement will show which of the forces is doing more of the work.

The Fed sets the overnight rate; the bond market sets the rest. Homebuyers waiting for cheaper mortgages will probably need weaker economic data before long yields fall, and further Fed cuts on their own will not do it. Unless the labour market softens again this autumn, thirty-year mortgage rates are more likely to hover above six per cent into next year than to fall back to where they were in September.