Why Do Mortgage Rates Care About Inflation?

Let’s start with a very simple example. I tell you that I am going to pay you $10 a month for the rest of your life, no strings attached, just because you’re you. You think to yourself, “That’s nice. I can buy lunch at McDonald’s with Rob’s generosity.” A few years go by, McDonald’s has gradually increased its prices, and $10 only buys a Big Mac and medium fries. A few years later, you’re only buying the Big Mac. Lo and behold, inflation has eaten away at your $10 fixed payment, which isn’t good for you or any of the millions of other investors who own fixed-income securities with the amount of “erosion” being determined by the pace of inflation. The value to you of the $10 has dropped.

Let’s view this another way. The value of bonds can fluctuate with changes in inflation rates. Investors’ expectations of future economic trends and how they, especially inflation, affect bond prices, help investors make informed decisions and manage expectations from their bond portfolios. Just as the general increase in prices of goods and services over time reduced the purchasing power of money in the example above, it can impact the value of a bond portfolio.

The U.S. Federal Reserve, as well as “central banks” around the world, do what they can to maintain inflation within a target range to ensure economic stability. But the Fed can only do so much, so when a waterway is blocked, or a tariff is imposed by the administration, or a drought raises wheat or corn prices, it can create havoc and a situation beyond the Fed’s control.

Whether it is a government or loans for families financing homes that are formed into a security backed by mortgages (MBS), a bond is a fixed-income security that represents a loan made by an investor to a borrower. The issuer promises to pay periodic interest (called the coupon) and repay the principal at maturity.

Let’s give a quick numerical example. If an investor buys a $1 million MBS with a 6% coupon rate, that investor will earn $60,000 per year. But the real value of that $60,000 depends on the prevailing inflation rate. If inflation rises to 4%, the real return (adjusted for inflation) is only 2%. So, inflation and bond prices share an inverse relationship: When inflation rises, bond prices generally fall.

To control inflation, the Federal Reserve may increase short-term rates. Higher interest rates make newly issued bonds more attractive since they offer better yields compared to existing bonds, so the market value of older bonds with lower coupon rates goes down. Who would want to own an MBS issued in 2021 yielding 3% when they could buy a new MBS yielding 6%?

Everyday bond yields reflect the return an investor expects based on market conditions. If inflation expectations increase, yields rise. Since yields and prices move inversely, bond prices drop, and this will impact the MBS market and be reflected in the rates on home loans. We have seen this happen with the war in Iran raising oil prices, and mortgage rates moving higher.

But not all bonds react to inflation the same way, including MBS. The valuation of mortgage-backed securities are influenced by maturity (30- and 15-year maturities, for example), type (pools of mortgages backed by fixed-rate or adjustable-rate loans), and coupon rate (with trillions of dollars of MBS outstanding, rates range from the twos into the eights for non-Agency pools). For example, long-term MBS are more sensitive to inflation changes because they lock in fixed returns for extended periods. Short-term bonds are less affected since they mature sooner, allowing reinvestment at newer rates. Pools composed of adjustable-rate mortgages adjust periodically based on prevailing interest rates, offering partial protection against inflation.

While inflation can erode bond value, investors can adopt certain strategies to mitigate its effects, and originators see these strategies play out eventually on the rates that they offer to borrowers. Nearly every investor in mortgages, whether they be a money manager, bank, hedge fund, insurance company, or portfolio lender, diversifies their holdings based on a variety of criteria, desired credit quality, and projections. For example, inflation expectations may cause the yield curve to steepen as long-term yields rise faster than short-term ones, so an investor will adjust their holdings.

Macroeconomic effects highlight why inflation is a key factor for policymakers and investors alike. No one wants to see the cash flow, or income, eroded by inflation, but that is what indeed can happen, impacting borrowers. When inflation rises, bond prices usually fall because investors demand higher yields to compensate for reduced purchasing power. Time will tell how oil prices and inflation play out over the summer, but it is important that originators understand these concepts so that they can explain them to borrowers.