Welcome to Thoughts on the Market.
I'm Jim Egan, co-head of securitized products research at Morgan Stanley.
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 1130 a.m. 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 in the affordability in the US homeowners market and the US mortgage market.
Before we get into what this could help, the affordability challenges how bad is that affordability right now?
Sure.
And, as we've discussed on this podcast in the past, one of the biggest issues with the affordability challenges in the US housing market specifically is how it's fed through to supply issues, as the lock-in effect has kept growing 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 425.
The prevailing rate for 30-year mortgages today is still over 6.25%.
So we're talking about two full percentage points, 200 basis points out of the money.
And that seems like a lot.
Has it been that way in the past?
If we look at roughly 40 years of data ending in 2022, The market was only 100 basis points out of 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 money for three entire years, 12 consecutive quarters.
So this is very unprecedented in the 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?
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.
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?
So mortgage rates are much more sensitive to the belly of the treasury curve, called the five and 10 year portions, than Fed funds.
They have a little bit sensitivity to the 30 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 five and the 10-year portion of the treasury curve, 10 years yield about 50 basis points more than the five-year note.
So, if you think about it, an investor could buy a 10-year note now, or they could buy a five-year note now and then another five-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 five-year note is, or they buy the five-year note right now, the five-year note in five years would have to yield 100 basis points above to get the average to be the same.
Well, if the five-year note in five years is 100 basis points above where the five-year note is right now, mortgage rates are also probably going to be higher in five years.
Okay.
So that's not helping the affordability issues.
What can be done to lower mortgage rates from here?
Well, going back to my inner nerd, if you brought the five and 10 year treasury yields down, That would certainly be helpful.
But mortgage rates aren't just predicated on where the treasury yields are.
There's also a risk premium on top of that.
And so if the mortgage originators can sell those loans to other investors at a tighter spread, that would also help bring the rate down.
And there are things that can be done on that front.
So, for instance, if the capital requirements for investors to own those mortgages go down, that would certainly be helpful.
You could try to incentivize investors in a number of different ways.
That's one front.
But in reality, a lot of these fees are already stuck in place.
So there's only so much that can be done.
Now, Jim, let's suppose I am wrong.
I've been wrong in the past.
A lot of times with you, I thought the Patriots were going to beat the Giants in both Super Bowls.
Somehow Eli Manning proved me wrong.
However, if the mortgage rate does come down, how much does it have to come down for housing activity to start picking up?
So this is a question we get asked roughly six to seven times a day.
How did Eli Manning beat the Patriots?
How far mortgage rates have to come down in order to really get housing sales started again.
Because of the backdrop of today's housing and mortgage markets that we laid out at the top of this podcast, it's really difficult to empirically point to a mortgage rate and calculate.
This is where rates have to fall to.
So what we have been doing instead is looking at historic periods of affordability improvement and seeing how much do we need to get that affordability ratio down to get a sustainable growth in sales volumes from here?
All right.
And how much do we have to get that affordability ratio down?
So a sustainable increase.
Historically, we've needed about a 10 percent improvement in the affordability ratio.
Help me out here.
I think about mortgage payments as more of a function of the rate level.
So if we're in the context of like six and a quarter, six and a half right now.
How far does the mortgage rate need to drop to get a 10 improvement, assuming that there's no change in borrower's income or home prices?
In that world, we think you need about a 100 basis point move.
It would take the 30-year mortgage rate to call it 5.5%.
All right.
So if mortgage rates go to 55, then we're going to immediately see housing activity pick up.
That is not exactly what we're saying.
What we've seen is the 10 improvement is enough to get sustainable growth in sales volumes a year after you start to see that real improvement.
The contemporaneous moves can be up, they can be down.
Given what our economists are saying for the labor market going forward, what they're saying for growth in the United States, we do think you can see a little bit of contemporaneous growth.
If you start to see that 100 basis point move in mortgage rates now, We think you'll get about a 5 increase in purchase volumes as we move through 2026 with the potential for upward inflection in 2027 from that 5 growth number again if we get that move in mortgage rates.
All right, so we expect the Fed to cut rates about 150 basis points over the next year and a half.
It doesn't necessarily have to bring the mortgage rate down, but if the mortgage rate does go down to in the context of 55, we should start to get a pickup in housing activity, maybe the year after that.
Jim, always a pleasure talking to you.
Pleasure talking to you too, Jay.
And to all of you regularly hearing us out.
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