The Federal Reserve has a simple playbook for fighting inflation. It goes like this: Continue to put upward pressure on interest rates until business and consumer spending across the economy weakens and inflation subsides.
Historically speaking, the Fed’s inflation-fighting playbook always hits the US housing market particularly hard. When it comes to housing transactions, monthly payments are everything. And when mortgage rates soar—which happens as soon as the Fed chases inflation—those payments go up for new borrowers. This explains why as soon as mortgage rates rose this spring, the housing market collapsed.
But that housing fix could soon be gone some steam.
Over the past week, mortgage rates have fallen rapidly. As of Tuesday, the average 30-year fixed mortgage rate stood at 5.05 percent, down from June when mortgage rates peaked at 6.28 percent. These reduced mortgage rates offer immediate relief to the stranded homebuyers. If a borrower in June took out a $500,000 mortgage with an interest rate of 6.28%, they would pay $3,088 a month in principal and interest. At 5.05%, that payment would be just $2,699. Over the course of the 30-year loan, that’s a savings of $140,000.
What happens? As economic data weakens, financial markets are pricing in a 2023 recession. This puts downward pressure on mortgage rates.
“The bond market is pricing in a high probability of a recession next year and that the recession will prompt the Fed to reverse course and cut [Federal Funds] rates,” says Mark Zandi, chief economist at Moody’s Analytics Luck.
While the Fed does not directly set mortgage rates, its policies affect how financial markets price both the 10-year Treasury yield and mortgage rates. In anticipation of a Fed rate hike and monetary tightening, financial markets are pushing up both the 10-year Treasury yield and mortgage rates. In anticipation of a lower Federal Funds rate and monetary easing, financial markets are discounting both the 10-year Treasury yield and mortgage rates. The latter is what we are now seeing in the financial markets.
Check out this interactive chart on Fortune.com
As mortgage rates rose earlier this year, tens of millions of Americans lost their eligibility for home loans. However, as mortgage rates begin to decline, millions of Americans are regaining access to mortgages. That’s why so many real estate professionals are cheering for lower mortgage rates: They should help boost home buying activity.
While lower mortgage rates will undoubtedly prompt more partial buyers to return to open houses, don’t pencil in the end of the housing correction just yet.
“The bottom line is that the recent drop in mortgage rates will help the margin, but the housing market will remain under pressure with mortgage rates at 5% (fewer sales, slowing home price growth),” wrote Bill McBride , author of the financial blog Calculated Risk, in his newsletter Tuesday. The reason? Even with the one percentage point drop in mortgage rates, housing affordability remains historically low.
“If we factor in home price growth, payments are up more than 50% year-over-year on the same home,” McBride writes.
There’s another reason housing bulls shouldn’t be overconfident: If recession fears — which are helping lower mortgage rates — turn out to be correct, it would cause some additional weakness in the industry. If someone is afraid of losing their job, they are not going to jump into the housing market.
“While lower rates alone are positive for housing, they are not when accompanied by a recession and rapidly rising unemployment,” says Zandi Luck.
Check out this interactive chart on Fortune.com
Where will mortgage rates go from here?
Bank of America researchers believe there is a chance the 10-year Treasury yield will fall from 2.7% to 2.0% over the next 12 months. This could cause mortgage rates to fall between 4% and 4.5%. (The trajectory of mortgage rates is closely correlated with the trajectory of the 10-year Treasury yield.)
But there is one big wild card: the Federal Reserve.
The Fed clearly wants to slow down the housing market. The pandemic housing boom – during which house prices soared 42% and home construction hit a 16-year high – was among the drivers of high inflation. Slower home sales and a decline in construction should provide relief for the overstretched US housing supply. We’re already seeing it: A steep decline in housing starts translates into reduced demand for everything from lumber framing to cabinetry and windows.
But if mortgage rates fall too quickly, a rebound in the housing market could upset the Fed’s fight against inflation. If that happens, the Fed has more than enough monetary “firepower” to once again put upward pressure on mortgage rates.
“Whether we’re technically in a recession or not doesn’t change my analysis. I’ve been focusing on the inflation data…And so far, inflation continues to surprise us to the upside,” Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, told CBS on Sunday. “We are committed to reducing inflation, and we will do what we have to do.”
Want to stay informed about the housing downturn? Follow me on Twitter at @NewsLambert.
This story was originally featured on Fortune.com