Fed Chair Janet Yellen. Photo courtesy the Federal Reserve.
If recent rises in interest rates have you thinking this is not a good time to lock in a fixed rate for, say, 30 years – think again.
The Federal Reserve disclosed this week that it is getting ready to shrink its bloated portfolio of securities, now totaling around $4.5 billion. This news would be exciting only to traders and economists, except for one thing: It means mortgage rates are going to go up, quite possibly faster and farther than they have up to this point.
Since December 2015 the Fed has boosted short-term interest rates three times, putting its current target between 0.75 percent and 1 percent. But longer-term rates have not risen commensurately. This has narrowed the “spread,” or the gap between two-year and 10-year Treasury rates, to just a little over 1.1 percent as of earlier this week – a historically low level, especially at a time when economic expansion may be gathering a little steam.
By shrinking its portfolio, the Fed will be targeting longer-term interest rates for an increase. And that matters a lot to mortgage borrowers, because the long-term federal borrowing rate is a key driver of mortgage rates. In fact, that 10-year Treasury rate is among the most popular benchmarks that banks use in setting their borrowing rates.
The stock market took matters in stride when news of the Fed’s emerging consensus broke on Wednesday. What had been a moderately good day for U.S. equities, bolstered by gains in commodity prices, merely turned into a mildly down day, with the S&P 500 index down about 0.3 percent. That calm response is important, because when the first hint of a boost in interest rates came in the spring of 2013, the market reacted with a notorious “taper tantrum” that ended up pushing the Fed’s first rate hike back by more than two years. The absence of any such extreme response this time around makes it all the more likely that the Fed will move farther and faster to try to get interest rates back to a more normal state after nearly a decade of heavy intervention.
Why did the market respond so calmly in the face of an obvious risk to the housing market? My guess is that it is because housing has, thus far, contributed very little to the economic expansion. At around 1.25 million units per year, housing starts right now remain near levels that were only touched during the recessions of 1980 and 1991, even after recovering a bit from the trough we reached at the depths of the recent Great Recession. When you’re down this low, almost anything looks like up.
Besides, a rise in long-term rates will probably encourage many borrowers to seek adjustable-rate loans that carry lower rates overall, and especially low “teaser” rates. This will be especially significant for millennials who, burdened by student loan debt and held back until recently by a slow job market, have not been quick to establish their own households and buy starter homes. Once they begin moving into the home market, they will likely trade in or trade up their first homes fairly quickly, which will leave them less exposed to the perils of future interest rate increases on those adjustable-rate loans. The likelihood of such a scenario will probably encourage Fed governors to go ahead with their move to drive long-term rates higher.
If things play out along these lines, the result will be a steeper yield curve, which is what we would typically expect to see in a mature economic recovery that is chugging along. In other words, something resembling normal. And it has been a long time since we saw anything of the sort in the credit markets.