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The Interest Rate Forecast for 2017

February 27, 2017

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We’ve been saying since December that 4%-plus on the 30-year loan would likely be the new norm going forward. With the Federal Reserve hinting that it would like to raise the federal funds rate (the base rate) up to three more times this year, it’s unlikely we’ll see a pullback in mortgage rates heading into summer as we did last year. 

That said, we don’t see much of an impetus for the 30-year loan to meander higher than 4.5%. We’ve already seen the Fed hedge on the idea that three rate increases could be forthcoming in 2017. In February, we’ve seen the yield on the 10-year U.S. Treasury note drift lower. Over the same time, we’ve seen gold prices drift higher. (The gold price will frequently move inversely to interest rates because the opportunity costs of holding gold drops with lower interest rates.) 

As we write, traders in fed funds rate futures contracts give 50/50 odds for a rate increase in May.  These same traders give the greatest odds to a 25-basis-point (0.25%) increase. 

Should that occur (and we wouldn’t be surprised if it didn’t) that doesn’t mean materially higher mortgage rates reside in the future. The fed funds rate is one variable in the interest-rate equation. The Fed’s balance sheet is the other variable. 

The Fed’s balance sheet holds $4.5 trillion of Treasury securities (mostly long term) and mortgage-backed securities (MBS) on the asset side. Before the 2008 financial crisis, the Fed’s balance sheet held $800 billion of Treasury securities (mostly short-term bills). Money supply is the corollary to the Fed’s assets. The more securities it holds, the more money the Fed has created. (The Fed pays for its securities with newly issued money.)  The Fed has stopped buying additional Treasury securities and MBS, but it has continually reinvested the proceeds as they mature. This has kept the money supply high, which has helped keep interest rates low. 

Fed officials have said they have no intention of reducing the balance sheet until the fed funds rate has been raised higher than its current level (no specifics have been given). When that occurs, then the Fed would consider reducing its assets, which, in turn, would reduce the money supply. (A dollar is a liability on the Fed’s balance sheet that’s offset by the securities it holds on the asset side.) 

We don’t think that we’ll see mortgage rates rise significantly higher (by a percentage point or more) until the Fed begins to reduce its assets, which would also reduce the money supply. When this happens, and it might not happen until next year or beyond, then we would expect to see a significant increase in market-interest rates and in mortgage-lending rates. 

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