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Mortgage rates retreated for the second day in a row Friday after a survey showed the manufacturing sector contracted in February for the 16th consecutive month, adding to the case that the Federal Reserve can cut short-term rates without fueling inflation.

Another key inflation metric, the personal consumption expenditures (PCE) price index, showed inflation continued to decelerate in January in line with economists’ expectations, bringing mortgage rates down by five basis points Thursday.

Friday’s release of the Institute for Supply Management’s Manufacturing PMI registered 47.8 percent in February, down 1.3 percentage points from January. A reading below 50 percent indicates the manufacturing sector is contracting.

While Fed policymakers are determined to get inflation back down to their 2 percent target, holding rates too high, for too long, could plunge the economy into a recession.

Oliver Allen

Oliver Allen, senior U.S. economist for Pantheon Macroeconomics, characterized the retreat in the ISM manufacturing survey as “disappointing,” but said “better times probably lie ahead.”

“We still expect the beginnings of a meaningful recovery in manufacturing activity to emerge over the next few months, as lower long-term rates drive a modest upturn in domestic capital investment,” Allen said in a note to clients Friday.

Key barometer for mortgage rates drops

Yields on 10-year Treasury notes have dropped for two days in a row on encouraging inflation data. Source: ICE Futures via Yahoo Finance.

Yields on 10-year Treasury notes, which are usually a good indicator of where mortgage rates are headed next, fell seven basis points Friday, to 4.18 percent, after the release of the ISM manufacturing survey. That’s a 17 basis-point drop from a 2024 peak of 4.35 percent registered on Feb. 22 — the highest rate since Nov. 30.

An index maintained by Mortgage News Daily showed rates on 30-year fixed-rate mortgages dropped five basis points Thursday, to 7.10 percent, and another 2 basis points Friday, to 7.08 percent.

The CME FedWatch Tool, which tracks futures markets to gauge the odds of the Fed’s next moves, shows investors don’t expect the Fed to cut short-term rates until June. But the odds of one or more Fed rate cuts by June 12 rose to 69 percent on Friday, up from 63 percent the day before.

The Fed doesn’t have direct control over long-term rates such as mortgages and Treasury yields, which are determined by supply and investor demand.

But the Fed is also a player in the market for Treasurys and mortgage-backed securities, having bought trillions of dollars in such investments to bring interest rates down during the pandemic and, before that, the 2007-09 recession. The Fed’s moves to trim its balance sheet, “quantitative tightening,” could keep mortgage rates from falling dramatically in the months ahead.

Fed trimming its balance sheet

Source: Board of Governors of the Federal Reserve System, Federal Reserve Bank of St. Louis

During the pandemic, the Fed was buying $80 billion in long-term Treasury notes and $40 billion in mortgage-backed securities (MBS) every month. The central bank’s $120 billion in monthly “quantitative easing” helped push mortgage rates to record lows — and the Fed’s balance sheet to record highs.

Having grown its holdings of Treasurys and MBS to $8.5 trillion, the central bank reversed course in the summer of 2022. To fight inflation, the Fed is now allowing up to $35 billion in maturing MBS and $60 billion in Treasurys to passively roll off the central bank’s balance sheet each month.

The Fed’s “quantitative tightening” means there’s less demand for Treasurys and MBS, which can limit how hard and how fast long-term rates decline.

In October, when mortgage rates were soaring to 2023 highs, housing groups including the National Association of Realtors urged Fed policymakers to take a break from quantitative tightening. If the Fed would just maintain its current mortgage holdings, that would bring down the wide “spread” between 10-year Treasurys and mortgage rates, the groups maintained.

In a Jan. 31 implementation note, Fed policymakers indicated they intend to continue trimming the Fed’s balance sheet by $95 billion a month.

At a monetary policy forum on Friday, Federal Reserve Governor Christopher Waller said recent research suggests the Fed can continue the current pace of balance sheet runoffs without harming the economy.

Christopher Waller

Demand for U.S. Treasurys “is broad and deep — the buyers are not a narrow set of deep-pocketed, sophisticated investors but rather the American public,” Waller said at the 2024 U.S. Monetary Policy Forum in New York. “As a result, the pace of runoff is not a problem.”

As of Thursday, the Fed still held $4.66 trillion in Treasurys and $2.4 trillion in mortgages on its books.

Waller said that while the Fed has had trouble hitting its target of reducing its MBS holdings by $35 billion a month, he’d like to see the Fed reduce its mortgage holdings to zero.

The Fed isn’t actively selling Treasurys or MBS — it just lets investments passively roll off its balance sheet by not replacing assets that mature.

“Agency MBS holdings have been slow to run off the portfolio, at a recent monthly average of about $15 billion, because the underlying mortgages have very low interest rates and prepayments are quite small,” Waller said. “I believe it is important to see a continued reduction in these holdings.”

In their latest forecast, Fannie Mae economists predicted mortgage rates will retreat below 6 percent this year, but come down more slowly in 2025. In a Feb. 20 forecast, economists at the Mortgage Bankers Association projected mortgage rates won’t drop below 6 percent in 2024, but will fall more steeply next year to an average of 5.5 percent in Q4 2025.

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