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Demand for homes remains above long-term averages, but scarce inventory means sales won’t likely pick up until mortgage rates move closer to 5 percent, according to analysts at Fitch Ratings.
Investors who fund most mortgages had already factored in Wednesday’s Fed rate cut, so they may need to be less cautious about funding home loans for mortgage rates to decrease further, cautioned Fitch analysts.
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“Housing demand, as measured by homes sold above list price and the average sale-to-list price, has softened since August 2023 but remains above long-term averages,” noted Fitch analysts. “A further decline in mortgage rates will help improve affordability and support demand, but low inventory will likely constrain home sales until rates move closer to 5 percent.”
For those monitoring mortgage rates closely, this week’s highly anticipated Fed rate cut may have seemed underwhelming.
After the central bank lowered short-term interest rates for the first time in 4 years and initiated a rate-cutting campaign with a 50 basis-point cut, rates for FHA and conforming mortgages actually rose slightly on Wednesday.
One reason for the increase in mortgage rates is that Fed policymakers had been hinting at rate cuts for months. Rates on 30-year fixed-rate conforming mortgages had already dropped by over a percentage point earlier in the summer after reaching a high in April 2024.
The monetary policy tools available to the Fed allow them to make precise adjustments to short-term interest rates, keeping the federal funds rate within a quarter percentage point of their desired target.
However, the central bank does not directly control long-term interest rates like Treasury yields and mortgages, which are largely determined by supply and demand. Investor decisions, based on factors such as inflation expectations, economic growth, and monetary policy, can influence long-term interest rates.
When asked about potential mortgage rate drops over the next year, Fed Chair Jerome Powell mentioned that it would depend on economic developments and pointed to the Fed’s latest Summary of Economic Projections for insights.
To combat inflation during the pandemic, Fed policymakers raised the federal funds rate 11 times between March 2022 and July 2023, reaching a target range of 5.25 to 5.5 percent — the highest level since 2001. The recent cut lowered the target to 4.75 to 5 percent.
The Fed’s “SEP” and “dot plot” indicate that the median expectation of policymakers is for the federal funds rate to be about 2 percent lower by the end of next year compared to before the rate cut.
“If things go as forecasted, other rates in the economy will also decrease,” Powell explained. “However, the timing of these changes will depend on economic performance. We can’t predict the economy’s trajectory a year in advance.”
Fed cut’s impact on mortgage rates
Rate-lock data from Optimal Blue showed that rates on 30-year fixed-rate conforming mortgages hit a new low of 6.03 percent on Tuesday but increased by 5 basis points after Wednesday’s Fed meeting.
A weekly survey by the Mortgage Bankers Association indicated a 5 percent increase in applications for purchase loans compared to the previous week, although they were slightly lower (0.4 percent) than a year ago.
Refinance requests saw a significant increase of 24 percent week over week and a staggering 127 percent from the same time last year. This surge in demand for conventional purchase mortgages that meet Fannie Mae and Freddie Mac’s criteria is attributed to improving affordability conditions, driven by lower rates and slower growth in home prices, according to MBA Deputy Chief Economist Joel Kan.
The rates on conforming mortgages have dropped more than a full percentage point from their peak of 7.27 percent in April 2024. Economists at Fannie Mae and the Mortgage Bankers Association had predicted in August that rates would reach this level by the end of the following year.
Looking ahead, Fitch Ratings analysts anticipate that 10-year Treasury yields, which influence mortgage rates, will remain around 3.5 percent by the end of 2026. This forecast is just a quarter percentage point lower than the current rate of 3.74 percent.
To further lower mortgage rates, the gap between 10-year Treasurys and 30-year mortgage rates needs to narrow, as highlighted by Fitch analysts. The spread, which typically averaged 1.8 percentage points before the pandemic, widened to 3 percent at certain times last year.
Investors are seeking higher returns on mortgage-backed securities due to prepayment risk, fueled by concerns that borrowers will refinance their loans when rates drop. Additionally, the Federal Reserve’s reduction in MBS and government debt holdings, known as “quantitative tightening,” has weakened demand for MBS.
As mortgage rates decrease, prepayment risk diminishes. Fitch analysts note that the 30-10 spread has already narrowed to 2.6 percentage points this year, and further narrowing will be necessary to push mortgage rates below 6 percent.
According to Fannie Mae economists, it may take time for declining rates to translate into increased home sales. High mortgage rates have made homes less affordable for buyers and led to a “lock-in effect” for sellers reluctant to give up their low-rate mortgages.
Federal Reserve Chairman Jerome Powell believes that lower rates will spur more supply in the housing market by alleviating the lock-in effect and encouraging more listings. This increase in supply could potentially offset any rise in demand resulting from lower mortgage rates.
Overall, the housing market is expected to benefit from the current trend of decreasing mortgage rates, leading to increased activity among buyers and sellers.