Investor Optimism Wanes as Bond Yields Rise, Pushing Up Mortgage Rates

As investors lose hope that the Federal Reserve may cut interest rates in the near future, U.S. bond yields are surging—and along with them, mortgage costs that had dipped in recent weeks.

The 10-year U.S. Treasury Note's yield reached as high as 3.96% this week. That's the highest since last fall, when it peaked at 4.23%, and up from 3.40% just three weeks ago.

One result: Higher costs on mortgages and home loan refinancings, because lenders use the 10-year yield as a benchmark for setting rates.

Meanwhile, stocks are sliding. The S&P 500 Index dropped 4% this month after surging 6% in January.

Investors Reassess

The Fed reduced the level of its recent rate hikes to 0.5% in December and 0.25% in late January after four straight increases of 0.75%. In doing it so, the central bank buoyed hopes it might soon halt the rate-hike campaign it started last year.

The sooner the Fed stops raising rates, investors' thinking went, the sooner it might start reducing them—perhaps as early as late 2023—as it tries to avoid throwing the U.S. economy into recession. Investors responded with a January buying spree that sent both stocks and bonds higher (bond yields move inversely to their prices).

However, a strong U.S. jobs report, hotter-than-expected monthly inflation reports, and the largest monthly gain in retail sales in two years have dashed those hopes.

Yields rose and stocks fell again Friday morning after the Fed's preferred inflation reading, the Personal Consumption Expenditures price index from the Department of Commerce, rose 5.4% in January from the same month a year ago, edging higher from 5.3% in December. Consumer spending also rose 1.8% in January after falling 0.1% in last month.

Fed officials have remained steadfast in their insistence that they'll continue raising rates until they're satisfied inflationary pressures have adequately eased. February's economic data hasn't done that.

BlackRock, the world's largest asset manager, warned a month ago that investors were too optimistic.

"Falling inflation has raised market hopes for rate cuts this year," BlackRock said in a Jan. 23 note to investors, "but that optimism may be built on shaky ground. We don't see rate cuts even once recessions hit."

Borrowing Costs, Deposit Rates

The Fed's efforts to reduce the highest U.S. inflation in four decades pushed Treasury yields last year to their highest levels since just before the 2008 global financial crisis.

Its steady rate increases beginning in March pushed the 10-year yield up from the historic COVID-19 pandemic low of 0.50% in August 2020.

As Treasury yields rose, so did borrowing costs. The average 30-year fixed rate on mortgages increased to 7% by early November from about 3.75% just before the Fed started raising rates.

That rate had fallen to almost 6% at the beginning of February but has rebounded to 6.5% in the past three weeks.

Rising yields assert upward pressure on other types of consumer loans as well. Banks and credit card companies, though, usually use the prime lending rate, which moves mostly in lockstep with the Fed's benchmark rate, as a gauge for setting rates on most of those loans.

One clear positive: As borrowing costs rise, savers benefit by earning higher returns on their bank deposits. U.S. money market rates reached an average of 4.3% in January, up from virtually zero just a year ago, and additional Fed rate hikes should boost them even further.