The residential housing market may never experience a boom quite like it did during the pandemic driven by a lack of housing supply after over a decade of under-building relative to population growth, strong demand across consumers thanks to fiscal support and the desire for more living space, and rock bottom interest rates. Since then, and as highlighted in a recent post, the rise in mortgage rates and home prices has crushed housing affordability, making achieving the American dream of home ownership unattainable for many people.

While we don’t expect home prices to decline materially from here given structural dynamics, Americans that have been sidelined from being able to purchase a home over the past couple of years are perhaps hoping and waiting for at least one area of reprieve: lower mortgage rates. We do see scope for mortgage rates to decline modestly from ~7% to 6-6.5% over the next 12-24 months, however, it’s unlikely we will see mortgage rates below 5%.

Mortgage rates are closely tied to long-term interest rates, in particular, the rate on the U.S. 10-year Treasury note. Given long term Treasury rates are primarily driven by growth, inflation, and expectations for policy rates in the long run, a cooling inflation and growth backdrop in the quarters ahead are likely to put modest downward pressure on long-term interest rates and contribute to some declines in mortgage rates. That said, increasing Treasury supply and rising neutral policy rate expectations are likely to limit any substantial fall in either Treasury or mortgage rates.

Mortgages rates are also influenced by the mortgage spread – the 30-year fixed rate minus the 10Y Treasury rate – and the factors that affect this spread. On average, the 30-year mortgage rate has been 1.7% higher than the US 10-year, but periods of economic stress (recessions), and changes in Federal Reserve (Fed) asset purchases of Treasuries and agency mortgage-backed securities (MBS) in recent decades have impacted this spread dynamic. On the former, its clear recessions and periods of economic uncertainty lead to spikes in mortgage spreads. This is consistent with an increase in market and interest volatility during periods of economic stress.

On the latter, the Fed began purchasing agency MBS following the Global Financial Crisis to help mitigate the volatility in the mortgage market. The impact of Fed purchases on mortgage spreads is clear; in December of 2008, the mortgage spread peaked at 2.9%. The Fed began MBS purchases from Jan. 2009 to March 2010, forcing that spread to tighten to 1.2% over that period. Similarly, the first experiment of quantitative tightening (QT) from 2017-2019 caused mortgage spreads to widen from 1.4% to 2.6%.

In summary, gradual declines in Treasury rates may be offset by wider mortgage spreads as the Fed continues to embrace QT in its MBS portfolio, likely keeping mortgage rates in the high 6% to low-7% range. That said, should mortgage spreads tighten to historical norms and long run Treasury yields decline to 3.5-4% by the end of 2025, we could see mortgage rates fall to 5.25%-5.75%, however we don’t foresee an environment where mortgage rates fall below that range, unless a recession occurs.

Crucially, declining mortgage rates are likely to be met with still strong demand for housing, keeping a floor on home prices and potentially allow home prices to continue rising. This suggests that even a decline in mortgage rates won’t dramatically improve housing affordability in the years ahead.

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