With risk-free interest rates not set to drop any further, and home sales constrained by record low inventory, the cost of the prepayment option on MBS will have fallen. Alongside Fed purchases of MBS, that helps explain the recent narrowing in the spread between 30-year mortgage rates and the 10-year Treasury yield. We expect it will edge back further, keeping mortgage rates close to 2.8% over the next couple of years.
- With risk-free interest rates not set to drop any further, and home sales constrained by record low inventory, the cost of the prepayment option on MBS will have fallen. Alongside Fed purchases of MBS, that helps explain the recent narrowing in the spread between 30-year mortgage rates and the 10-year Treasury yield. We expect it will edge back further, keeping mortgage rates close to 2.8% over the next couple of years.
- The arrival of COVID-19 caused the spread between the 30-year mortgage rate and 10-year Treasury yield to blow out to 295bps in March last year, matching the highs seen during the height of the financial crisis. (See Chart 1.) Since then, it has narrowed steadily, returning to its pre-COVID level of 195bps by December. That helped push the 30-year mortgage rate to a record low 2.86% by the middle of December and has helped keep mortgage rates low even as yields have ticked up.
- A number of factors explain the movement in spreads over the past year. The initial jump reflected increased market stress and concerns over liquidity. Banks did not want to extend mortgages at a time when their capital was coming under pressure from increasing risk of default on their assets.
- Since then, action to support the economy and the arrival of vaccines have improved the economic outlook, cutting the risk of delinquencies. Admittedly, 5.4% of mortgages are still in forbearance, and the ban of foreclosures means the backlog of delinquent loans is building up. But lenders have tightened credit standards in recent months, with the median credit score on new loans rising to a record high 786 in the third quarter. And strong house price growth means the negative equity share has fallen to just 3.0%. (See Chart 2.) That has improved lenders’ confidence and increased their willingness to lend.
- A couple of other factors also help explain the narrowing in spreads. First, the Fed has resumed their MBS purchasing programme, with a commitment to buy $40bn of MBS a month. Second, with mortgage rates already at record lows and unlikely to fall further, the cost of hedging prepayment risk will have dropped. Given that we are expecting stable house prices and lending standards over the next few years, and with inventory at record lows, the risk of a surge in prepayments driven by a boom in home sales is also low.
- With the cost of the prepayment option now reduced, we expect spreads will drop back to around 175bps. Admittedly, the Fed’s support will not last forever. But that will only be withdrawn once economic recovery is well established, and the cut in MBS holdings seen over 2018 and 2019 didn’t have an adverse impact on the spread. (See Update.) Accordingly, with the 10-year yield set to stay close to 1.0% over the next couple years, that means 30-year mortgage rates will hold close to 2.8%.
Chart 1: Spread Between 10-Year Treasury Yield & 30-Year Mortgage Rate (bps)
Chart 2: Median Credit Score & Share of Mortgages in Negative Equity
Sources: Refinitiv, MBA, Capital Economics
Sources: NY Fed, CoreLogic
Matthew Pointon, Property Economist, firstname.lastname@example.org