I make a regular habit, since I’m detached from the bond markets now, of looking at the (admittedly simple) Bloomberg table below. It’s accessed via the “markets” tab on the home page, and shows closing yields of U.S. Treasury bills, notes, and bonds with maturities from three months to 30 years. Lately, it’s reflected how inverted the yield curve is, which is when short rates are higher than long rates. (The Financial Times, incidentally, published a wonderful, educational primer on the yield curve here.)
When I contemplate the current inversion and the probabilities associated with it, it gives me a pretty strong sense of what’s likely to happen in the mortgage markets and what’s likely to happen with Santa Fe home prices over the next few years.
But not for the reasons you might think.
A 116-Basis-Point Inversion Is Nuts
With the Fed Funds target rate set at 5.25% to 5.50% (this is the rate banks charge one another for overnight loans) and the 10-year Treasury having closed on March 12 at 4.17%, it’s becoming apparent that the prospects for mortgage rates drifting significantly lower are dim, whether the Fed lowers the target rate or not.
With the Fed funds effective rate (a weighted average of real-world Fed funds trades) at 5.33% on March 12 and the 10-year yield at 4.17%, the 10-year is a jaw-dropping 116 basis points below the overnight rate. And fixed-rate mortgages are priced off of the 10-year yield.
Closing Yields as of March 12, 2024
Inversion Happens Only About 10% of The Time
The yield curve is, over time and on average, rarely inverted. The rule of thumb my fixed income portfolio manager friends use is that over a 50-year period, one might see the curve inverted perhaps 10% of the time. It’s comparatively rare. Borrowing for longer periods is normally more expensive than borrowing for shorter periods because there’s less risk in lending your money out for a shorter time. Bond geeks call higher rates of long-term borrowing the “term premium.”
So if the curve is flat or normal 90% of the time and the 10-year yield is now at 4.34%, what happens when the curve normalizes? If you concluded something to the effect of “nowhere to go but up,” you may be pretty close to the truth.
What about Potential Fed Funds Cuts?
Let’s return to short-term rates for a moment. Recently, most economists had predicted that the Fed would cut overnight rates in the March 20 meeting, or barring that, certainly by the July 31 meeting. But in the face of a screaming economy with full employment and almost all other indicators showing things at full tilt, the Fed has very little incentive to ease. So the forecasts on the timing of the first cut have been pushed back again and again, now from the March to the July meeting.
Even if we do assume a Fed cut as early as March 20, what does that mean for mortgage rates?
Very likely, almost nothing.
Fed rate cut odds as predicted by the Chicago Merc
What Will The Return of A Normal Curve Mean?
If the yield curve reverts to what it has done 90% of the time (a flat or normal shape), we might be looking at a 10-year yield of 5.00% or so, and with the 10-year at 5.00%, mortgage rates would be around 8.00%. Moves higher than 5.00% in the would push mortgage rates above 8.00%.
Many of the most respected minds in finance believe that 10-year yields will remain high not just over the next year or two but high over the next decade. So even if the Fed cuts by a full percent and the curve normalizes, mortgage rates may stay at current levels or climb higher.
Yes, even with Fed funds a full 100 basis points lower than they are now, mortgage rates would more likely be higher than lower, because it’s unlikely that the curve remains inverted. It’s simply much more common, by a factor of about 10, for the curve to be flat or sloping upward. In terms of probability, it’d be a simple reversion to the mean. To be clear, we are only discussing probabilities here. Just because a certain pattern (the curve only being inverted 10% of the time) has taken place in the past, does not mean it will necessarily do so in the same manner in the future. But in finance, these things tend to be a decent guidepost.
But Higher Rates Are Good for Santa Fe Home Values
Higher rates, as I wrote here, are keeping those with cheaper mortgages in their homes, restricting existing-home supply. In Santa Fe, the $400,000 to $1,200,000 range is very tight. The longer rates are high, the longer supply will remain tight. We have such steady demand here from Colorado, Texas, Arizona, and California that demand has continued to edge out supply, quite reliably.
New-Home Construction in Santa Fe Won’t Fill The Gap
In some locales, new-home construction can move in to fill the gap. This tends to be where new home construction is freer and subject to fewer municipal regulations and environmental restrictions. In Santa Fe, building is not like it is in Houston (thankfully). Santa Feans are averse to sprawl, building permits are hard to come by, and in general, new-home building remains tepid. Prices, therefore, are likely to keep up their steady climb.
If you own a home in steady-demand Santa Fe, this is all very good news. The capital appreciation you may expect over the next several years will net a healthy return on funds — especially if they’re borrowed. Painful as the entry may be, compelling investment potential remains.
Leave a Reply