Mortgage rates hit 5 month lows last week but quickly jumped to the highest levels in more than a month this week. While last week’s strong jobs report certainly served as a catalyst, there’s more to the story.
Fortunately, the story is fairly simple. It began in October when rates hit decades-long highs and finally began to make progress back toward lower levels. Inflation had been a pivotal component of the surge and inflation reports were starting to moderate in November and December. Simply put, a rate recovery made good sense.
In fact, lower inflation was desperately anticipated by financial markets. Interest rates, especially, had been on the defensive, waiting for a sign that the worst was over. Q4, 2022 arguably provided that sign, but there were serious questions to be answered about what would come next for rates.
The market began answering those questions in January. Mortgage rates and popular benchmarks like the 10yr Treasury yield had fallen an entire percentage point, but then paused to wait for the green light to drop some more.
Rates were right to be hesitant. By falling as much as they had, they were already playing a dangerous game of chicken with the Federal Reserve. The Fed controls and sets the shortest-term interest rates in an effort to control inflation. The Fed Funds Rate doesn’t directly dictate mortgage rates, but changes in the Fed’s rate outlook definitely impact mortgage rates. Conversely, a big enough drop in mortgage rates can carry implications for inflation (the thing the Fed is trying to fight by raising short-term rates).
Here’s where that game of chicken comes in. The market had been betting that the Fed would be forced to cut short-term rates by the end of 2023 even though Fed members had repeatedly said rates wouldn’t top out for a few more months at minimum and then remain at the ceiling for a year or two. The market thought the Fed was bluffing or wrong. Either way, those defiant expectations helped mortgage rates hit 5 month lows last week.
Then the jobs report happened (last Friday). It also happened 2 days after the Fed’s latest policy announcement. Markets began to panic. What would the Fed have done if it knew the jobs report would be so strong? Panic was amplified by the fact that Fed Chair Powell was scheduled for an informal Q&A the following Tuesday (February 7th) at the Economics Club of D.C. (a venue that would surely generate relevant questions).
Even before Powell took the stage, the market was already rethinking its game of chicken. Whereas Septembers Fed Funds Rate had consistently been expected to be lower than June’s, traders were quickly beginning to believe it would be unchanged. The following chart shows those expectations over time, both for the June and September Fed meetings. Note the gap that had existed up until this week.
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