High Mortgage Rates and a Stuck Housing Market

Jay Bacow (0:00)

Jim, getting a lot of questions about mortgage rates. We've been flying across the country talking to people.

Are your arms tired?

James Egan (0:08)

I'm hoping that all the extra flapping will give them just a little bit more definition, so we can show them off as we talk about adjustable rate mortgages.

Jay Bacow (0:15)

And that is the definition of an arm.

Welcome to Thoughts on the Market. I'm Jay Bacow, Co-Head of Securitized Products Research at Morgan Stanley.

James Egan (0:23)

And I'm Jim Egan, the other Co-Head of Securitized Products Research at Morgan Stanley.

Jay Bacow (0:28)

Today, we're here to talk about mortgage rates. How quickly they've moved, why they're here, where they might go, and what it means for the mortgage and housing market. It's Thursday, October 8th at 9 a.m. in New York.

Jim, as of this recording, the 10-year is over 5.3 percent. Rates haven't closed this high since 2002 The third-year mortgage rate is around 7.5 percent. It's about 150 basis points up since the beginning of February.

James Egan (1:02)

Right. There have been quick moves in rates that has led to quick moves in mortgage rates. There are a lot of implications to that, from affordability, housing market, mortgage market. But when we think about the relationship between mortgage rates and interest rates, Jay, there's also a feedback mechanism there.

Convexity hedging is what it's typically called. Can you discuss the role that that might have played in this current episode and what we should expect going forward?

Jay Bacow (1:30)

Sure. So, the biggest driver of mortgage rates is treasury rates. And treasury rates are driven by a number of factors. And right now, most people would point to inflation expectations and geopolitical concerns. However, as treasury rates go higher, homeowners that currently have a mortgage are less likely to move.

And because they're less likely to move, that means that the average life of those mortgages that investors own gets longer. And because mortgage investors typically want to keep their duration profile constant, as the average life of those mortgages gets longer, they are then going to need to either sell those mortgages or sell treasuries, which will cause yields to go even higher.

And there's a bit of a feedback loop on that, which can pressure yields and mortgage rates even higher. But what we would say is, at this point, we don't think there's a huge mechanism of that going through at this rate level. The average mortgage rate that homeowners have in America is almost exactly four and a half percent. Obviously, they're less likely to move as rates go up, but there are 300 basis points out of the money. So, from that point, it matters, but it didn't matter as much as when rates were a little lower. However, Jim, seven and a half percent mortgage rate, what does this do for housing affordability? Can you put that in context?

James Egan (2:59)

Yeah, so if we just think about this in terms of what a seven and a half percent mortgage rate implies for the monthly payment on the median priced home, we are now up over $325 if we use that seven and a half percent, assuming home prices are where they are today, incomes are where they are today. That monthly payment is up over $325 from where we are at local lows in February, or where we were at local lows in February. That's a 17% increase in terms of that monthly payment over just a seven month period.

Jay Bacow (3:29)

All right, so 17% increase over a seven month period, that's kind of scary, but as you and I have talked about in the past, given the fixed rate nature of the US mortgage market, it's a tad misleading for the average homeowner in America. So what does this do to sales? Obviously, it's scary for new homeowners, though.

James Egan (3:52)

Right, like you brought up the implications from a duration perspective, a convexity hedging perspective. All of this is just how the lock in effect continues to have material implications for the housing market, for mortgage markets. But yes, these affordability issues, not that bad for homeowners who have an average rate of 4.5%, that's not changing. Over 90% of the balance or count of mortgages, depending on how you want to look at it, in the United States, remains fixed rate. Their payments aren't changing. Right? But the marginal homebuyer, things are getting less affordable. I don't like to use the term demand destruction. I think that sounds a little bit too over the top here, but we are seeing some of our higher frequency or more leading indicator demand metrics show a little bit of softening here. Pending home sales, past two months, 3% to 5% down year over year. Purchase applications, which had been very strong.