Mortgage rates aren’t directly influenced by Federal Reserve
policy. However, the Fed’s recent cut likely will have a domino
effect on the US housing market, say our Co-Heads of Securitized
Products Research Jay Bacow and James Egan.
----- Transcript -----
Jay Bacow: Welcome to Thoughts on the
Market. I'm Jay Bacow, Co-Head of Securitized Products Research
at Morgan Stanley.
James Egan: And I'm Jim Egan, the other
Co-Head of Securitized Products Research at Morgan Stanley. And
on this episode of the podcast, we're going to discuss the
impacts of a 50-basis point cut from the Fed on the US housing
and mortgage markets.
It's Wednesday, October 16th at 1 pm in New York.
Now, Jay, the Fed cut 50 basis points at its last meeting. What
are your views on the mortgage market in the aftermath of that
cut?
Jay Bacow: We think that is constructive
for mortgages and we recommended a long mortgage basis versus
rates. The healthy economy and a Fed that doesn't want to fall
behind the curve should be good for risk assets in general. We
think there's a likelihood of vol possibly falling and that is
constructive for agency mortgages in particular.
Now it's a positive narrative. But, the valuations matter, and we
have to admit that the valuations are not that compelling with
spreads on agency mortgages trading near the tights since the
regional bank crisis. However, if you look further back,
mortgages start to look attractive, particularly relative to
other high quality fixed-income assets.
For instance, agency mortgages are basically trading at the
average spread they've traded at since the GFC. Corporate credit,
on the other hand, is trading within a few basis points of the
tights since the GFC. If risk assets are going to do well, and
we're certainly seeing that in corporate credit and in the stock
market, we think mortgages are particularly priced attractively
relative to most of them.
James Egan: Alright, so relative value for
mortgages makes sense, but can you talk a little bit about the
technicals here?
Jay Bacow: The technicals are where we feel
more confident. One of the reasons why mortgage spreads have been
wide for the past two years – it's an environment where the Fed
and the domestic banks, the two largest holders of mortgages,
have been reducing their holdings.
Now, we still expect the Fed to reduce their holdings of
mortgages, but we think the bank demand is going to turn
positive. That's due to not just clarity around the Basel III
Endgame that should be coming soon, but more directly related to
this conversation – as the Fed cuts rates that directly impacts
the amount of yield that banks earn of the cash sitting at the
Fed.
Now, that is projected to continue to go down as the Fed cuts
rates. What's not projected to continually go down very much is
the yield on the securities that they can be buying in mortgages.
So, the incentive for them to move out of cash and into
securities, and those securities likely to be mortgages, is
picking up as the Fed cuts rates. And it's not just the banks
that are going to be more active. It's also overseas investors.
As the Fed cuts rates and the Bank of Japan hikes, the FX
(foreign exchange) hedging costs, which is basically a function
of the interest rate differential between the two banks is likely
to decrease, which means that overseas investors will be more
active.
A steeper curve is going to be positive for REIT demand. And then
over time, as the Fed cuts rates and money market yields go down,
those retail investors are likely to be incentivized to move out
of money market funds into core funds with higher yields, which
will be supportive of money manager demand – although that's
likely a 2025 story.
James Egan: All right, Jay, thank you for
that. But one of the questions that you and I have received a lot
since the Fed's cut is: Okay, the Fed cut 50 basis points. Why
haven't mortgage rates come down by 50 basis points on the
follow?
Jay Bacow: Well, so, mortgage rates,
obviously in the US, the vast majority of them are 30-year fixed
rate mortgages. And so, if you have one, the Fed actions don't
impact that. If you have an adjustable-rate mortgage, it will
reset – but typically those resets happen every six months.
Although you're probably getting asked about the prevailing
mortgage rate; and the prevailing mortgage rate – because it's
the 30-year fixed rate, it's not a function of Fed funds – but
it's more of a function of the yields further out the curve.
Although maybe Jim, you can do a better job explaining this.
James Egan: So, when it comes to interest
rates and mortgages, Jay, as you mentioned, we're going to be
more focused on the five- and 10-year part of the curve than we
are on Fed funds.
To provide a little bit of an example there, from the fourth
quarter of 2023 until the Wednesday morning that the Fed cut,
30-year mortgage rates had decreased by 180 basis points. The Fed
had yet to cut a single basis point. But, just taking a step back
from that cut specifically, mortgage rates have come down
significantly from the fourth quarter of 2023.
Jay Bacow: Right, and those mortgage rates
coming down significantly has improved affordability. But what's
maybe a little surprising is that hasn't really led to a pickup
in sales volumes. How should we think about that moving forward?
James Egan: So as mortgage rates have come
down, we have seen an increase in mortgage applications, but
that's been driven almost entirely by refinance applications.
Purchase applications, and that's going to be what's behind home
sales, those have been more or less treading water for the past
12 months. This relationship makes sense, in our view. As
mortgage rates have come down, housing remains unaffordable. It's
just more affordable than it was in the second half of 2023.
But, if you were one of the people who bought a home over the
past 24 months, and, to put that into context, that was the
lowest number of home sales over a 24-month period since the
second quarter of 2013. But if you were one of those people,
there's a good chance that you're in the money to refinance right
now.
Jay Bacow: And that's something that we're
seeing in the data. We've talked about the truly refinance
indicators on this podcast in the past, and it measures the share
of mortgages that have at least 25 basis points of incentive to
refinance after accounting for closing costs.
Right now, only about one in six of the outstanding borrowers
have incentive to refinance. Now, that's up from pretty close to
zero at the end of 2023, but if you just look at borrowers that
have taken out their mortgage in the past two years, almost
two-thirds of them have incentive to refinance.
Now, Jim, does that mean that purchase volumes are doomed to
languish around these levels?
James Egan: No, but the reaction might not
be as strong as some people are hoping for. While affordability
has improved, it remains challenged. And the lock in effect has
become a very popular phrase in the US housing and mortgage
markets. And that's still in play. 75 per cent of the
conventional mortgage universe still has a mortgage rate below 5
per cent.
Even with the prevailing rate at 6 per cent today, the effective
mortgage rate on the outstanding universe is 200 basis points out
of the money. That's better than 350 [basis points] out of the
money like we saw last year. But that would still be the worst
that it's been in 40 years.
Jay Bacow: And presumably, that is why we
have this continually tight inventory.
James Egan: Exactly. Now, as rates come
down, we are starting to see listings increase, but it's barely
made a dent in the historically low nature of the existing
housing supply. The existing home sales typically grow in the 12
to 24 months following affordability improvement, but not
necessarily in that initial period while affordability is
improving.
So relative to history, we're actually not underperforming that
much from a sales perspective. And we should be beginning that 12
to 24 months sweet spot in the fourth quarter of [20]24. We just
started that two to three weeks ago. While we expect existing
home sales to increase, we think the growth is going to be modest
relative to history and we're calling for 5 per cent growth in
the coming 12 months.
On the home price side, a lot of this is in line with our current
view. So, we think you're going to continue to see the pace of
growth slow. It's already started to slow. We think we get from
about 5 per cent today to 2 percent by the end.
Jay Bacow: All right, so the Fed cutting
rates is not likely to cause mortgage rates to drop materially.
We expect a modest pickup in housing activity. We expect home
price growth to slow, but still end the year positive; and it
should be supportive for mortgage spreads versus treasuries.
Jim, always a pleasure talking to you.
James Egan: Pleasure talking to you too,
Jay.
Jay Bacow: Thanks for listening. And if you
enjoy this podcast, please leave us a review wherever you listen
and share Thoughts on the Market with a friend or colleague
today.
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