For mortgage rates, bad news is good news 

Decisions in residential real estate are often based on market data — sometimes conflicting, often confusing. Housing Market Decoded, authored by economists and other market experts, helps put the data in context so you can make sense of the numbers.

Over the last several months, homebuyers have shown that they're still sensitive to changes in mortgage rates. When rates declined to around 6% last September, that shift helped kick off four straight months of year-over-year gains in existing home sales, according to the National Association of Realtors.

Conversely, when mortgage rates moved back up toward 7% in January, buyers took their feet off the gas, causing existing and pending home sales to stall. So what would it take for mortgage rates to return to a downward trend this year?

3 economic variables affect rates

Mortgage rates tend to move in parallel with the 10-year Treasury yield, which is influenced by three key ingredients: real economic growth, inflation and government borrowing — plus investors' expectations for the future course of all three. 

These factors help explain what happened to interest rates in the last six months and where rates might be going next.

'Bad news' led to lower rates last fall

If we wind the clock back to last September when the Fed was deciding whether to cut the Federal Funds Rate, policymakers and investors faced shrinking job gains, rising unemployment and slowing economic growth — a slew of bad news that was summed up by the Citigroup Economic Surprise Index, an indicator of whether economic data releases have been beating or missing forecasts, which plunged into negative territory in the spring and summer of 2024.

These factors helped fuel a decline in 30-year fixed mortgage rates, which dropped from a peak of 7.22% at the start of May to 6.08% by late September. The flip from positive to negative economic surprises tends to be followed by declining mortgage rates — and vice versa.

Why rates ticked up again 

Higher inflation expectations and larger anticipated deficits came to the fore in the new year as investors grappled with mounting evidence that the post-pandemic inflation cooldown had mostly run its course and Congress got to work on plans for deficit-widening tax cuts.

While the five-year inflation rate dropped below 2% last September, it had climbed above 2.5% by late January. Meanwhile, Citigroup's index tipped below 0 in February amid an escalating trade war and falling stock market indices.

The return of negative economic factors caused mortgage rates to decline for seven straight weeks — from 7.04% on January 16 to 6.63% on March 6, according to Freddie Mac. This is an example of the "bad news is good news" world we are now living in, where negative economic news is the most likely force to push mortgage rates down now (so be careful what you wish for).

Where rates are headed next

The gap between mortgage rates and 10-year Treasury yields — known as "the spread" — is historically high right now at 2.3 to 2.4 points. Before the pandemic, it hovered between 1.4 and 2.0 points, and in May 2023 soared above 3 points due to market volatility and the rise in prepayment risk that mortgage lenders faced on loans likely to be refinanced quickly.

But the spread has now shrunk more than halfway back to its pre-pandemic range. If the decline continues, it could drop to 2% by 2026. At today's 10-year yield of around 4.25%, that would pull mortgage rates down to about 6.25%, similar to the rates that jump-started sales activity last September. 

Unlike the negative shocks to economic data we've seen this year, a shrinking spread is a trend everyone can root for.

Jeff Tucker is the Principal Economist for Windermere Real Estate, where he analyzes economic data to explain its impact on national and regional housing markets. He previously spent five years at Zillow, researching housing market trends, authoring reports and presenting to policy makers. The views expressed in this column are solely those of the author.