Can Fed Cuts Bring Mortgage Rates Down?

Summary

Podcast Summary: Thoughts on the Market

Episode: Can Fed Cuts Bring Mortgage Rates Down?
Date: September 15, 2025
Hosts: Jim Egan & Jay Bacow (Co-Heads of Securitized Products Research, Morgan Stanley)

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Episode Overview

This episode explores the current challenges with mortgage affordability in the U.S. housing market, the anticipated Federal Reserve rate cuts, and whether these cuts are likely to bring down mortgage rates. Jim Egan and Jay Bacow examine the persistent “lock-in” effect that is keeping supply tight, break down the relationship between Fed policy and mortgage rates, and discuss what’s really needed to potentially spur housing activity.

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Key Discussion Points & Insights

1. Affordability Crisis and the Lock-In Effect

• Current State: Homeowners with existing low mortgage rates (average below 4.25%) are disincentivized to move given new mortgage rates are over 6.25%, keeping supply off the market ([00:48]).
  • "The effective rate on the outstanding mortgage market, kind of the average of the mortgages outstanding, is below 4.25%. The prevailing rate for 30 year mortgages today is still over 6.25%" – Jim Egan ([00:48])
• Historical Perspective: This situation is highly unprecedented; never before in the past 40 years has the "out-of-the-money" spread (between current and prevailing mortgage rates) been this large for so long—over 200 basis points for three consecutive years ([01:23]).
  • "We have now been more than 200 basis points out of the money for three entire years, 12 consecutive quarters. So this is very unprecedented in the past several decades." – Jim Egan ([01:27])

2. Will Fed Cuts Lower Mortgage Rates?

• Key Takeaway: Cuts in the Federal Funds Rate are not directly bringing down mortgage rates.
  • "The Fed has already cut rates 100 basis points over the past year. And since the Fed has cut rates 100 basis points in the past year, the mortgage rate is 25 basis points higher." – Jay Bacow ([01:59])
• Yield Curve Relevance: Mortgage rates are significantly more sensitive to the mid-range (5- and 10-year) Treasury yields rather than the Fed Funds Rate ([02:39]).
  • "Mortgage rates are much more sensitive to the belly of the treasury curve, called the five and ten year portions, than Fed funds." – Jay Bacow ([02:39])
  • Jay (“nerding out") explains how the spread between 5- and 10-year notes implies that if 5-year yields rise in the future, mortgage rates could remain elevated ([02:39]–[03:39]).

3. Other Factors Keeping Mortgage Rates High

• Risk Premium: In addition to Treasury yields, there is a spread (risk premium) over Treasuries which can be influenced by factors like investor demand and capital requirements for holding mortgages ([03:46]).
  • "Mortgage rates aren't just predicated on where the treasury yields are. There's also a risk premium. ... If the capital requirements for investors to own those mortgages go down, that would certainly be helpful." – Jay Bacow ([03:46])
• Structural Limitations: Many fees and requirements are "stuck in place," limiting the impact of any changes ([03:46]).

4. What Would It Take to Boost Housing Activity?

• Affordability Ratio: Historically, a 10% improvement in the affordability ratio is needed for sustainable growth in housing sales ([05:24]).
  • "A sustainable increase. Historically we've needed about a 10% improvement in the affordability ratio." – Jim Egan ([05:24])
• Translation to Mortgage Rates: Dropping mortgage rates by about 100 basis points (from 6.25% to 5.5%) could, theoretically, provide this 10% improvement ([05:49]).
  • “We think you need about 100 basis point move. It would take the 30 year mortgage rate to call it 5 and a half percent.” – Jim Egan ([05:49])
• Timing of Impact: The boost in housing sales isn't immediate; growth tends to pick up about a year after affordability improves ([06:01]).
  • "A year after you start to see that real improvement, the contemporaneous moves can be up. They can be down... we do think you can see a little bit of contemporaneous growth if you start to see that 100 basis point move in mortgage rates." – Jim Egan ([06:01])
• Forecast: With such a drop in rates, the hosts expect a 5% increase in home purchase volumes through 2026, with a possible upward inflection in 2027 ([06:38]).

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Notable Quotes & Memorable Moments

• Historical Context:
  "If we look at roughly 40 years of data ending in 2022, the market was only 100 basis points out of the money for eight individual quarters. The most it was ever out of the money was 135 basis points. We have now been more than 200 basis points out of the money for three entire years, 12 consecutive quarters." – Jim Egan ([01:27])
• Humor & Analogy:
  "I thought the Patriots were going to beat the Giants in both Super Bowls. Somehow Eli Manning proved me wrong." – Jay Bacow ([04:10])
• Realistic Conclusions:
  "It doesn't necessarily have to bring the mortgage rate down, but if the mortgage rate does go down to, in the context of five and a half percent, we should start to get a pickup in housing activity. Maybe. Maybe the year after that." – Jay Bacow ([06:38])

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Key Timestamps for Reference

• [00:48] – Explanation of lock-in effect and spread between average and current mortgage rates
• [01:23, 01:27] – Historical comparison of out-of-the-money mortgage rate periods
• [01:59] – Assessment of past Fed cuts and their effect (or lack thereof) on mortgage rates
• [02:39] – Discussion of mortgage rates' sensitivity to the yield curve
• [03:46] – Breakdown of risk premiums and structural hurdles for lower mortgage rates
• [05:21–05:49] – What type of mortgage rate move could improve affordability
• [06:01–06:38] – How soon and how much could home sales rise after an improvement in mortgage rates

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Summary Table

| Segment | Discussion Focus | Timestamp | |-----------------------------------|--------------------------------------------------------------------|------------| | Affordability & Lock-In | Average vs. current mortgage rates; unprecedented spread | 00:48–01:27| | Fed Cuts & Mortgage Rates | Why mortgage rates may not drop, yield curve relevance | 01:59–03:39| | Other Factors (Risk Premium etc.) | What else could lower rates, but structural factors limit impact | 03:46 | | Needed Rate Drop | 10% affordability improvement = ~100 bps rate cut | 05:21–05:49| | Expected Housing Activity Pickup | 5% growth in purchase volumes if rates drop to 5.5% | 06:01–06:38|

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Takeaway

Federal Reserve interest rate cuts are not enough to ensure lower mortgage rates. Market pricing, the Treasury yield curve, and risk premiums play major roles. Even if mortgage rates eventually fall, significant improvement in affordability—and therefore in housing activity—will likely happen slowly and require more than just Fed action. A drop to roughly 5.5% on 30-year mortgages would be necessary for meaningful change, with tangible results in home sales possibly lagging by a year or more.

Transcript

[A]

Welcome to Thoughts on the Market. I'm Jim Egan, co head of securitized products research at Morgan Stanley.

[B]

I'm Jay Bacow, the other co head of securitized products research at Morgan Stanley. Today we're talking about the Fed mortgage rates and the implications to the housing market. It's Monday, September 15th at 11:30am in New York. Now Jim, the Fed is meeting on Wednesday and both our economists and the market are expecting them to cut rates in this meeting and continue to cut rates at least probably two more times in 2025 and multiple times in 2026. We've talked a lot about the challenges in the affordability in the US Homeowners market, in the US Mortgage market. Before we get into what this could help. The affordability challenges. How bad is that affordability right now?

[A]

Sure. And as we've discussed on this podcast in the past, one of the biggest issues with the affordability challenges in the US housing market specifically is how it's Fed through to supply issues as the lock in effect has kept home with low 30 year mortgage rates from listing their homes. But just how locked in does the market remain today? The effective rate on the outstanding mortgage market, kind of the average of the mortgages outstanding is below 4.25%. The prevailing rate for 30 year mortgages today is still over 6.25%. So we're talking about 2 full percentage points, 200 basis points out of the money.

[B]

And that seems like a lot. Has it been that way in the past?

[A]

If we look at roughly 40 years of data ending in 2022, the market was only 100 basis points out of the money for eight individual quarters. The most it was ever out of the money was 135 basis points. We have now been more than 200 basis points out of the money for three entire years, 12 consecutive quarters. So this is very unprecedented in the past several decades. But Jay, our economists are calling for Fed cuts. The market's pricing in Fed cuts. How much lower is the mortgage rate going for these affordability equations?

[B]

We actually don't think that the Fed cutting rates necessarily is going to cause the mortgage rate to come down at all. And one way we can think about this is if we look at it, the Fed has already cut rates 100 basis points over the past year. And since the Fed has cut rates 100 basis points in the past year, the mortgage rate is 25 basis points higher.

[A]

Okay, so if I'm not going to be looking at Fed funds for the path of mortgage rates going forward, I have Two questions for you. One, what part of the treasury term structure should I be looking at? And two, you talked about the market pricing in Fed cuts from here. What is the market saying about where those rates will be in the future?

[B]

So mortgage rates are much more sensitive to the belly of the treasury curve, called the five and ten year portions, than Fed funds. They have a little bit sensitivity to the 30 year note as well. And when we think about what the market is expecting those portions of the treasury curve to do, I apologize, I'm going to have to nerd out. Fortunately, being a nerd comes very naturally to me. If you look at the spread between the 5 and the 10 year portion of the treasury curve, 10 years yield about 50 basis points more than the 5 year note. So you think about it, an investor could buy a ten year note now, or they could buy a five year note now and then another five year note in five years. And they should expect to get the same return if they do either one. So if they buy the 10 year note right now at 50 basis points above where the 5 year note is, or they buy the 5 year note right now, the 5 year note in 5 years would have to yield 100 basis points above to get the average to be the same. Well, if the five year note in five years is 100 basis points above where the five year note is right now, mortgage rates are also probably going to be higher in five years.

[A]

Okay, so that's not helping the affordability issues. What can be done to lower mortgage rates from here?

[B]

Well, going back to my inner nerd, if you brought the 5 and 10 year treasury yields down, that would certainly be helpful. But mortgage rates aren't just predicated on where the treasury yields are. There's also a risk premium. On top of that, if the mortgage originators can sell those loans to other investors at a tighter spread, that would also help bring the rate down. And there are things that can be done on that front. So for instance, if the capital requirements for investors to own those mortgages go down, that would certainly be helpful. You could try to incentivize investors in a number of different ways. That's one front. But in reality, a lot of these fees are already sort of stuck in place. So there's only so much that can be done Now. Jim, let's suppose I am wrong. I've been wrong in the past a lot of times with you. I thought the Patriots were going to beat the Giants in both Super Bowls. Somehow Eli Manning proved me wrong. However, if the mortgage rate does come Down. How much does it have to come down for housing activity to start picking up?

[A]

So this is a question we get asked roughly six to seven times a day.

[B]

How did Eli Manning beat the Patriots?

[A]

How far mortgage rates have to come down in order to really get housing sales started again? And because of the backdrop of today's housing and mortgage markets that we laid out at the top of this podcast, it's really difficult to empirically point to to a mortgage rate and calculate this is where rates have to fall to. So what we have been doing instead is looking at historic periods of affordability improvement and seeing how much do we need to get that affordability ratio down to get a sustainable growth in sales volumes from here.

[B]

All right, and how much do we have to get that affordability ratio down?

[A]

So a sustainable increase. Historically we've needed about a 10% improvement in the affordability ratio.

[B]

Help me out here. I think about mortgage payments as more of a function of the rate level. So if we're in the context of like six and a quarter, six and a half right now, how far does the mortgage rate need to drop to get a 10% improvement? Assuming that there's no change in borrowers income or home prices in that world.

[A]

We think you need about 100 basis point move. It would take the 30 year mortgage rate to call it 5 and a half percent.

[B]

All right, so if mortgage rates go to 5.5%, then we're going to immediately see housing activity pick up.

[A]

That is not exactly what we're saying. What we've seen is the 10% improvement is enough to get sustainable growth in sales volumes. A year after you start to see that real improvement, the contemporaneous moves can be up. They can be down. Given what our economists are saying for the labor market going forward, what they're saying for growth in the United States, we do think you can see a little bit of contemporaneous growth if you start to see that 100 basis point move in mortgage rates. Now we're going to. We think you'll get about a 5% increase in purchase volumes as we move through 2026 with the potential for upward inflection in 2027 from that 5% growth number. Again, if we get that move in mortgage rates.

[B]

All right, so we expect the Fed to cut rates about 150 basis points over the next year and a half. It doesn't necessarily have to bring the mortgage rate down, but if the mortgage rate does go down to, in the context of five and a half percent, we should start to get a pickup in housing activity. Maybe. Maybe the year after that. Jim, always a pleasure talking to you.

[A]

Pleasure talking to you too, Jay. And to all of you regularly hearing us out, thank you for listening to another episode of Thoughts on the Market.

[B]

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[A]

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[C]

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