Those in the mortgage business hoping that the spread between the 10-year Treasury and 30-year fixed loan are on their way to normalizing — leading to lower rates — could be waiting a while longer, First American Financial said.
For quite some time, the spread has been in the area of 300 basis points, versus the 170 basis points commonly seen since the end of the Great Recession, noted Odeta Kushi, deputy chief economist, in a commentary. Some observers have defined the normal spread range as being between 150 basis points and 200 basis points.
Many industry economists expect those spreads to narrow by the end of 2023, with mortgage rates coming down accordingly. The August forecast by the Mortgage Bankers Association for example, foresees a 6.2% average for the 30-year FRM by year-end, versus 6.8% in the third quarter.
"That expectation is rooted in the belief that cooling inflation and more certainty about the outlook for monetary policy will result in a narrowing of the spread," Kushi said. "However, some of the drivers of the widening of the mortgage rate spread will likely remain sticky, which may prevent mortgage rates from meaningfully declining."
Kushi forecasts rates remaining between 6.5% and 7.5% for the rest of 2023. The average according to the Freddie Mac Primary Mortgage Survey has been over 7% for four weeks in a row and is likely not slipping back under that level in the near future.
The driver of those wider spreads in place since January 2022 are risks in the secondary market component, primarily duration from the expected life of a mortgage-backed security, which has lengthened in a quickly changing rising interest-rate environment.
As a result, spreads widen because MBS investors require more compensation from the interest rate to deal with higher uncertainty in their portfolio due to the longer than expected life of the underlying loan.
Spreads between agency mortgage-backed securities and long-term Treasuries have been around 165 basis points lately, a report from BTIG analyst Eric Hagen noted.
Forecasts regarding where they're headed next may diverge because certain factors in the composition of the current market make them less predictable. In addition, the drivers vary a bit in different parts of the secondary market.
"It's hard to pinpoint how much MBS spread sensitivity sits at the short end of the yield curve, considering the majority of the borrower's prepayment option is still modeled/driven off long-term interest rates," Hagen said.
Private-label MBS also are subject to credit risk, something that is not a problem with conforming or government securitizations, Kushi noted.
Supply and demand are also factors that play a role in how wide spreads are, as the U.S. government has ended its MBS purchase program and is no longer a buyer.
So when the Federal Reserve ends this current round of economic tightening and investors have more certainty, spreads could tighten, but it may take some time.
"And, if the spread narrows, then mortgage rates could come down even if the benchmark 10-Year Treasury stays the same," Kushi said. "But the prepayment and duration risk will remain because so many homeowners remain rate-locked into much lower mortgage rates."
How long that will be the case is difficult to tell because it's not clear when the Fed may start lowering rates again, or what the right target federal funds rate level is for the current economy," said Kushi.
