The Impact of the Expected Reduction in Interest Rates on Housing
There is a nearly universal sentiment in the homebuilding industry that lower interest rates are coming, and that will usher in a surge of demand from homebuyers and simultaneously reduce the cost of capital for builders and developers. But we have to consider: (1) how much will the fed funds rate fall, and (2) how much of an effect will that have on mortgage rates? After all, 30-year fixed mortgage rates are not directly tied to the rate that the Fed controls. The Federal Reserve has shifted to a more expansionary posture; that has become clear. The timing and magnitude of these cuts going forward will depend on economic indicators such as GDP growth, employment figures and, most crucial of all, inflation.
Impact on Long-Term Interest Rates
A reduction in the federal funds rate generally leads to lower short-term interest rates, but the relationship between the Fed’s policy rate and long-term interest rates, such as those on 10-year Treasury bonds, which heavily influence mortgage rates, is less direct. Long-term rates are determined by market forces, including investors’ expectations about future inflation, economic growth and the federal government’s fiscal health.
While an expected cut in the Fed’s rate may put downward pressure on long-term rates, this effect could be muted by other factors. For instance, the massive federal budget deficit and rising national debt could lead to increased government borrowing, which in turn could push up yields on long-term Treasury bonds. Investors may demand higher yields to compensate for the perceived risks associated with a higher debt burden and potential future inflation.
The Connection to Mortgage Rates
Mortgage rates are closely tied to the yields on 10-year Treasury bonds, although they typically include an additional spread to account for credit risk, liquidity and other market conditions, and that spread has been unusually wide lately. When the Fed cuts its policy rate, it can indirectly influence mortgage rates by affecting the broader economic outlook and investor sentiment. A reduction in the fed funds rate often leads to lower yields on government securities, which can reduce the cost of borrowing for homebuyers.
Brad Hunter runs Hunter Housing Economics, a national consultancy based in West Palm Beach, Florida.