By Telis Demos at Realtor.com and The Wall Street Journal 

It makes sense that mortgage rates are up. But by this much? That requires some explanation.

Freddie Mac’s weekly average 30-year fixed mortgage rate has cracked 7% for the first time in two decades, a rise just shy of 4 percentage points from the end of last year. By contrast, benchmark 10-year U.S. Treasury yields are up around 2.5 points. What this means is that the gap—or spread, in financial lingo—between mortgage rates and Treasury yields has ballooned.

For the past decade, the spread between a measure of average national mortgage rates and 10-year Treasury yields has averaged 1.8 points, according to figures tracked by Autonomous Research. This year began right around that level. But with Treasurys yielding over 4%, the spread now at roughly 3 points is about as high as it has been this century. 

Other times that the spread has seen comparable widening were in late 2008 and March 2020, when the financial crisis and pandemic, respectively, were driving investors to the haven of Treasurys. In both cases, the Federal Reserve stepped up to buy more mortgage bonds, bringing spreads and mortgage rates down, as spreads on mortgage bonds are a key component in the mortgage rates ultimately charged to borrowers. 

This time, that isn’t happening: The Fed this year, as part of its plan to shrink its balance sheet, has stopped purchases of agency mortgage-backed securities. Those are packages of mortgage loans issued by government-sponsored enterprises such as Freddie and Fannie Mae.

Watch: As Mortgage Rates Surpass 7%, What’s in Store for Homebuyers?

On top of that, the Fed’s overall tightening of policy has contributed to a reduced appetite for bond buying by banks. As rates have risen, drastically fewer people are refinancing their mortgages and paying them off early. That increases the expected lifespan of mortgages and MBS. But the appeal of a longer-duration asset diminishes when banks’ deposits are more prone to quickly reprice in response to higher rates.

Together, banks and the Fed own about 75% of the agency MBS market, according to Bank of America strategists. Without those buyers, there has been more volatility in that market, which also contributes to widening spreads between MBS and Treasurys.

Though investors could be tempted by wide spreads on MBS, one concern holding buyers back is that the gap could possibly widen even further as the Fed fights inflation, says Jeana Curro, head of agency MBS strategy at Bank of America. “Over the past few sessions, there’s enough investor interest to keep spreads contained, but not enough to drive them tighter,” she said. “The risk is that without that demand, spreads could get wider.”

Another component of mortgage rates is what mortgage originators can earn for selling mortgages into the market. A proxy for this is the spread between rates charged to borrowers and the yield on current MBS. As volumes have plunged and volatility has jumped, originators are often not in a position to offer lower mortgage rates to entice borrowers, as they have needed to protect their own economics.

Analysts at Morgan Stanley in late October noted that spreads on agency MBS were closer to their widest post-Covid levels than spreads for corporate credit, which were in about the middle of their range since May 2020. The difference, the analysts said, is that banks have been major MBS purchasers but aren’t generally big buyers of corporate credit. The relative spread widening in MBS is a consequence of banks trying to manage their balance sheets, they said.

One form of a possible silver lining for mortgage bonds—and in turn, mortgage borrowers—is that agency MBS may outperform other credits during recessions. The fact that MBS spreads are currently wider relative to recent history than corporate credit spreads, which generally suffer in recessions, might even accelerate that effect.