Let’s take a very simple example: An investor has $100,000 in cash to invest and buys a mortgage-backed security earning 6.00 percent. So, for the next 30 years they will earn $6,000 per year, or $500 per month. This is good because their monthly food bill is $500, so they have that covered.

As 2025 begins all is good. They receive $500 in income and spend $500 on food. But wait! As the year moves along, consumer prices are up and their monthly food bill goes from $500 to $505 to $510 to $525 by the end of the year, an inflation rate of 5 percent. The owner of the bond’s purchasing power has dropped, and they need to earn more, or spend less, just to tread water. So, when investors are looking to buy another security, they will insist on a higher interest rate to make sure they end up with the same (or better) real return. As a result, as inflation rises, interest rates go up. That, in a nutshell, is why the bond market keeps a close eye on inflation, and investors often weigh future purchasing power against whether or not something is a safe investment.

Inflation is the rise in prices for goods and services, and one of the things that the U.S. Federal Reserve works to do, in its mission to help economic stability, is control inflation by raising or lowering short-term interest rates. Inflation, which impacts the value of money, makes interest rates go up and bond values go down. When the economy is slow and inflation is negligible, the Fed may lower short-term rates, as we saw in late 2024 and early 2025. If the U.S. economy is strong, and inflation is a concern, the Fed may choose to raise short-term interest rates to reduce the demand for credit and help prevent the economy from overheating.

When the Fed raises, or is expected to raise, short-term rates, intermediate and longer-term rates, including mortgage rates, also tend to go up. Since bond prices and yields move in opposite directions, rising yields mean falling prices. That means a lower value for investors’ fixed-income investments. In the case of mortgage-backed securities, value changes during the day or week might be quite small, but over time will add up. LOs may hear their capital markets staff say, “The bond market is selling off,” meaning that prices are going down, and rates are moving higher.

While we’re explaining why investors are concerned about inflation, terms that are commonly used are “nominal returns” versus “real returns.” Simply put, the nominal return is what a bond or bond fund provides on paper. The real return is adjusted for inflation. So, an MBS investor might purchase a mortgage-backed security that pays 6 percent, but if the rate of inflation is 5 percent, their real return is only 1 percent (6-5). That’s not much.

That said, a little inflation is actually a sign of a healthy economy. How much is too little or too much? Economists argue about that incessantly. The average rate of inflation in the United States since 1913 has been 3.2%. It is skewed somewhat by the high-inflation periods of World War I, World War II, and the 1970s, but it still means that investors needed to earn an average annual return of 3.2% just to stay even with inflation.  

During the pandemic and soon after, however, the annual inflation rate for the United States jumped to 8.2 percent for the 12 months that ended September 2022. Many have assigned blame to the Federal Reserve for keeping rates too low for too long after they cut rates at the beginning of the pandemic. The inflation rate prompted the Fed to raise rates quickly in 2022 and 2023, and then gradually reduce rates in 2023 and 2024 as inflation subsided.

Lenders know, however, that interest rates don’t operate in a vacuum. Credit risk is very important and appears in many examples around the world. Put another way, investors in U.S. mortgage-backed securities may also consider buying Egyptian government securities, or bonds issued to finance a school’s construction in Alabama, or debt issued by the U.S. Treasury. In some cases, investors are willing to trade a negative real return in exchange for safety, deciding that preserving their principal is more important than yield. In other cases, an investor may prefer to “go up the risk curve” to improve their yield, and buy non-Agency MBS such as those backed by jumbo or Non-QM loans.