Articles : Interest Rates and the Housing Market

March 2003 - by Sara Chaloen, Research Analyst

California continued to experience strong housing market conditions as the median home price appreciated more than 17 percent year-to-year, reaching $336,740 in January. At the same time, housing affordability dropped from a year ago with only 29 percent of households in California able to afford the median priced home. Housing affordability would have fallen further, if it weren’t for the historically low mortgage rates. Mortgage rates that are at the lowest levels since the 1960s are the primary reason for continued strength in the housing and refi markets.
So what does affect mortgage rates and where are they likely to go in the coming months? When people think of mortgage rates, they also think about the Fed and changes to the Fed Funds rate, the borrowing rate banks charge each other on overnight loans. Although changes to the Fed Funds rate directly affect short-term interest rates, the actual changes do not directly affect long-term interest rates including mortgage rates.
Historically, yields on mortgage rates move in line with yields on the 10-year Treasury Note. As yields on the 10-year Treasury Note reached a 40-year low of 2.48 percent in March, yields on 30-year Fixed Rate Mortgages also attained their lowest level since 1965, 5.67 percent in February, according to Freddie Mac.
Changes in expectations are the biggest influence on long-term interest rates. Even though changes in short-term interest rates do not directly affect long-term rates, they are linked by expected inflation. Expectations of actions taken by the Fed and expected inflation rates directly affect both the 10-Year Treasury Note and mortgage rates. If inflation is expected to increase in the near future, we may see long-term interest rates head upward. The fundamental concerns of investors in the long-term market, including those who invest in Fannie Mae and Freddie Mac bonds, have to do with the profitability of those bonds. If inflation is higher than the yield for a long-term bond, investors would shy away from putting money into such an investment. When the economy is slow, inflation is unlikely to rise rapidly, allowing for the low long-term interest rate environment we have been experiencing lately.
Of course, a change in the economy or expectations of where inflation rates are going will definitely cause long-term rates to change course. The Bush Administration’s plan to cut taxes and boost spending may result in the issuance of more long-term debt. As the supply of Treasury Bonds increases to fund the deficit, the price of these bonds will drop and cause their yields to rise. According to historical trends, mortgage rates will most likely follow suit. Now that the war with Iraq has started, uncertainty of whether or not there will be a war is over. Rising optimism that the war will be over shortly could stimulate the economy. A faster paced economy, coupled with an increase in defense spending in the coming months, may cause upward pressure on long-term interest rates including mortgage rates. However, the increase in rates should be slight as excess capacity in the economy, and the smaller amount of defense spending relative to GDP as a whole, will not create too much inflationary pressure.