Mortgage Rates Are Unlikely to Fall Much Further, Even With the Fed’s Upcoming Rate Cuts

Mortgage rates fell from over 7% to 6.1% over the summer, as markets anticipated the Fed’s September 18 interest-rate cut. Now that the cut has happened and a few more cuts are expected, mortgage rates may fall a bit further, into the high-5% range. But they’re unlikely to fall much more than that. 

Generally speaking, mortgage rates move in the same direction as the Fed rate. The U.S. Federal Reserve controls an overnight lending rate for banks, while mortgage rates are long-term interest rates set by bond markets. 

But mortgage rates typically move earlier, anticipating Fed actions, and may move more or less than the short-term rates controlled by the Fed as bond investors change their long-term expectations for the economy.  In the coming year, assuming the U.S. doesn’t enter a recession, mortgage rates are expected to fall as the Fed cuts. But the decline in mortgage rates will be much smaller than the Fed cuts. That’s because most of the Fed cuts have been priced in by bond markets, and long-term rates may increase relative to short-term rates as a recession becomes less likely.

Background: Different types of interest rates

• The Federal Reserve sets the Fed Funds rate, a riskless overnight lending rate for banks. 
• All other interest rates in the economy will differ from the Fed Funds rate based on (1) how long money is lent for, and (2) how much risk there is that the money won’t be paid back. For example, the 10-year treasury yield is a long-term rate but it carries virtually no risk. Mortgages are long-term rates and they carry risk of default and refinancing.

How the Fed’s actions translate to mortgage rates

• To make the jump from the Fed Funds rate to mortgage rates, we have to consider two factors. The first is the yield curve, which is how 10-year treasuries are currently priced relative to short-term rates. The second is the mortgage spread, which is how much higher mortgage rates have to be relative to 10-year treasury yields to account for the risk associated with mortgages.
  • • Yield curve: The difference between a riskless long-term rate like 10-year treasury yields and the Fed Funds rate can be negative or positive, depending on how investors in the Treasury market expect inflation, short-term rates, and economic growth to change over the long term. The Fed has little control over these rates. 
      • In forming these expectations, investors are incorporating expectations of any Fed cuts. Long-term rates are lower than short term-rates when inflation, interest rates, and economic growth are expected to be lower in the future than now, and higher when the opposite is true. 
      • Currently, 10-year treasury yields are lower than the Fed Funds rate, which generally coincides with a high Fed Funds rate and significant recession risk. But that is likely to reverse as the Fed cuts the Fed Funds rate and recession risk diminishes.
    • Mortgage spread: Mortgage rates are generally higher than 10-year treasury yields to account for the risk associated with borrowers defaulting or refinancing. 
      • How much higher is determined by investors in the mortgage backed securities (MBS) market. 
      • That difference increased a lot in 2022 because interest rate volatility was higher, the risk of refinancing was higher with the higher level of rates, and there was less demand for MBS with the Fed ending quantitative easing and commercial banks pulling back from MBS. 
      • It has since come down a little because interest rate volatility has decreased, and the risk of refinancing is lower with rates coming down. We expect this gap between 10-year treasury yields and mortgage rates to continue to decline, but perhaps not all the way back to its pre-2022 average.

Here’s what is expected for mortgage rates as the Fed cuts rates

The Fed has already cut the Fed Funds rate by 50 basis points (bps) and is expected to cut by another 200 bps by the end of 2025. 

If we assume the Fed does exactly that and there is no recession, mortgage rates are likely to decline, but by much less than the Fed Funds rate: Mortgage rates would probably decline to 10-40 bps lower than where they are right now. That would mean mortgage rates declining to the 5.7% to 6.0% range, from about 6.1% right now. 

There are two main reasons mortgage rates would fall by much less than the Fed Funds rate. One, most of these cuts are already priced in by bond markets (that is why mortgage rates fell over the summer). Two, the relationship between long-term treasuries and short-term rates as well as the relationship between mortgage rates and treasuries will likely change. 

In other words, as the Fed Funds rate is cut, long-term treasury yields are likely to fall by less than short-term rates resulting in long-term rates being higher than short- term rates (rather than lower as they are currently). At the same time, the difference between mortgage rates and long- term treasury yields is likely to decrease.

Those two factors combine to yield a lower mortgage rate than today, but the decline will be much smaller than the Fed Funds rate decline.