December 20, 2024
Preface
Shifting sentiment among investors and a change in political leadership have fostered a bit of re-thinking about the outlook for interest rates. Over the course of this year, investors moved from expecting perhaps as many as six rate cuts in 2024, to perhaps none, to several. The Fed's own outlooks for policy did little to discourage wide swings in these expectations.
While it is true that inflation is lower than in recent years, it is also true that progress in pushing inflation down to the Fed's 2% core PCE target stalled some months ago. In the middle of the year, Fed concerns began to shift away from worries about price pressures and more towards a changing outlook for labor conditions. This prompted a forecast in September by Fed members that perhaps a full percentage point of cuts would come before 2024 was complete.
Conditions change, though. Overall economic growth has continued to power on, posting a near 3% pace in each of the last two quarters and a current run rate of about the same level so far in the fourth quarter. Not that they were all that soggy then, but labor conditions now appear less weak than they did a few months ago, and annualized core PCE inflation remains about 40% higher than the Fed's goal. Despite solid overall conditions, the Fed's September forecast of a full one-point cut in rates by 2025 has now come to realization.
It's from here the forward path becomes foggy. Even with solid conditions, the Fed likely felt comfortable in cutting rates since the difference in core inflation to the nominal federal funds rate (the so-called "real" rate) was still strongly positive, and thought to be "restrictive", although to what degree remains unclear as evidence of restriction remains scant.
While equity markets have mostly cheered on the Fed actions, bond markets see things differently. Since the initial 50-basis cut of this new Fed cycle back in September, the influential yield on the 10-year Treasury has risen appreciably, climbing by more three-quarters of a percentage point. In turn, this dragged rates on fixed-rate mortgages upward by about the same amount, lifting them from close to 6% in late September to closer to 7% again by mid-late November, and they've mostly held in a higher range since.
If there's any good news to come out of that increase, it is perhaps only that mortgage rates now have at least some room to fall. The questions, of course, are how much, how fast, and how soon.
Recap
Looking at the last forecast, well, we'll have to take our lumps on that one. We got caught up in the hopes that the decline in mortgage rates would mostly hold as the Fed continued to ease policy, but the economy and inflation worries pressed longer-term rates in the opposite direction of our expectations. Our October forecast missed the mark by a wide amount; for the average offered rate for a conforming 30-year FRM as reported by Freddie Mac, we expected to see rates run in a 5.98% to 6.43% range, but rates went in the other direction, running between 6.54% and 6.84% over the nine-week stretch.
Things were rather better when it came to rates for ARMs. We anticipated that the initial fixed interest rate for hybrid 5-year ARMs as reported by the Mortgage bankers Association would wander between bookends of 5.75% to 6.25%, and for that most part, that held true. There were only two weeks out of nine outside of those borders, and the range for rates for the most common ARM wandered in a 5.81% to 6.34 range. We'll call that fair enough.
Forecast Discussion
Stubborn inflation is at the heart of this forecast discussion. For mortgage rates to find space to decline, inflation needs to resume at least a gradual downward path. This has not been the case for seven months now; the last real improvement came when core PCE prices stepped down from 2.9% to 2.7% back in May. Since then, no real progress has been made; a hopeful slip to 2.6% in June was short-lived, and has now been offset by 2.8% figures for October and November. Overall, core PCE prices have managed to hold about a 2.7% rate for the last seven months, a level still well above the Fed's target.
The Fed cut rates three times during fall 2024, largely in response to progress it had already made on inflation. However, it became increasingly apparent that the bond market largely disapproved of the 100-basis point reduction in the federal funds rate while inflation failed to make more routine progress toward two percent. The December trim in rates came despite growth in the second half of 2024 coming in faster than the Fed expected and inflation running warmer than forecast, and with the cut in rates, another selloff in bonds ensued, lifting yields again.
While the Fed believes that monetary policy is still "meaningfully restrictive," signs of restriction are few. GDP growth has run at about a 3% pace in each of the last two quarters, and is on track so far for about the same rate for the fourth quarter. This above "potential" rate can serve to foster inflation, or at least prevent it from declining much, if at all.
Financial conditions are fairly loose, as evidenced by lofty equity prices and other measures. Labor market conditions are looser than they were, and have returned to a level where they are no longer a significant source of inflationary pressure. Per Mr. Powell, labor conditions are "not cooling in a quick (sic) or in a way that really raises concerns." However, whether headline or core, by either CPI or PCE measure, inflation is stable at a level rather above target and stubbornly so. Restrictive monetary policy would tend to see inflation still declining, and it isn't.
Bond markets haven't much cared for the Fed's recent actions or outlooks. Long-term interest rates are most affected by inflation trends, and since the surprise 50-basis point cut in rates back in September, longer-term rates and mortgage rates have moved measurably higher. This trend wasn't improved with the December rate cut and new forecast for firmer inflation next year. In addition to this, bond investors are wary about the unknown impact on inflation from any changes to tariff and immigration policies the incoming administration has promised.
Monetary policy changes work their way through the economy with long and variable lags. While financial markets may react quickly, it's reasonable to think the effect of a decrease in rates by the Fed can take six months or more to be fully realized across the economy. While the Fed cut rates early this fall to address emerging weakening in labor market conditions, those have since largely subsided, and perhaps the November and December cuts are intended as a kind of insurance against the prospects of slowing in the economy and labor markets next year.
For those pining for much lower mortgage rates, we like to caution that the lowest rates come in the worst economic climates. No one should wish for those just to see lower financing costs; after all, you can't qualify for a mortgage if you don't have a job. At present, we don't have terrible economic conditions, but quite the opposite, and these conditions are accompanied by inflation that has proven difficult to subdue. In such conditions, it's really difficult for long-term interest rates to decline. For them to do so, we'll need to see some softening around the margins of the economy and at least some fresh progress in quelling inflation.
Forecast
The coming couple of months seem unlikely to produce the kind of conditions that will foster much lower mortgage rates. Inflation may cool from present levels, but probably not enough to change the overall picture much or sway the Fed toward faster or more cuts in rates. The economy has shown solid momentum over the last couple of years and is cruising along at a above-potential rate now for about the last nine months. Labor conditions have cooled, and may continue to, but even a speedier slowing over the winter months still likely won't put them in a position of significant concern.
With this in mind, there's likely not a whole lot of downside for mortgage rates over the coming nine-week forecast period. It's likely that 30-year fixed mortgage rates can't much improve on their December low of 6.6%, and probably won't manage to get too much higher than November's recent peak. Leaving a little room on both side of those levels leads us to expect that the average offered rate for a conforming 30-year fixed-rate mortgage as reported by Freddie Mac will likely run in a range of 6.55% to 7.05% over the next nine weeks.
Even with the additional cut in short-term rates, the outlook for the initial fixed rate for hybrid 5-year ARMs isn't much changed from where it was over the last forecast period. As reported by the Mortgage Bankers Association, we third the offered rate for 5-year ARMs will manage to trend between 5.7% and 6.2% between now and late February.
This forecast expires on February 21, 2024. By then, the groundhog will have seen his shadow (or not), and the spring housing season will be getting underway. Why not check back in to see whether this forecast has put up green shoots or is as barren as a winter landscape?
Between now and then, interim forecast updates and market commentary can be seen in our weekly MarketTrends newsletter. You can sign up to get MarketTrends by email, too.