As you may have heard, the Federal Reserve recently cut interest rates by 50 basis points (I always wanted to say that so that I can sound like all the reporters on CNBC-way more erudite than 0.5%). But when I saw this headline in WSJ, it got me curious: Why Mortgage Rates Have Stayed High Despite the Fed Cutting Rates. Understanding the complex relationship among interest rates, treasury yields, and mortgage rates was a session of macroeconomics that I didn’t know I needed! So brew yourself some tea and settle in…..

When the Fed cuts interest rates, many people expect mortgage rates to drop as well. However, mortgage rates don’t always respond directly to the Fed's actions. This is because mortgage rates are more closely tied to Treasury yields than the Fed’s benchmark rates.

The Relationship Between Mortgage Rates and Treasury Yields

Mortgage rates follow Treasury yields because both are influenced by similar economic factors, and Treasury yields serve as a benchmark for determining the cost of borrowing. Here’s a detailed explanation of why this connection exists:

Treasury Yields as a Benchmark for Long-Term Debt

Treasury bonds, especially the 10-year Treasury note, are considered the safest long-term debt instrument in the financial market. Since they are backed by the U.S. government, they are virtually risk-free. This makes their yields a baseline for many types of loans, including mortgages, which are also long-term debt instruments.

Mortgage rates typically add a "risk premium" to Treasury yields because mortgages are less secure than government debt. For example, homeowners might default on their loans, while the U.S. government is extremely unlikely to default.

Risk and Return

Mortgages are inherently riskier than Treasury bonds. To attract investors to mortgage-backed securities (MBS) — bundles of mortgages sold to investors — lenders must offer rates higher than Treasury yields to compensate for the added risk.

As Treasury yields rise or fall, mortgage rates adjust accordingly to maintain competitive returns for investors.

Market Demand and Competition

Treasury bonds and MBS compete for investment dollars. When Treasury yields rise, MBS need to offer higher returns to remain attractive to investors, which leads to higher mortgage rates. Conversely, when Treasury yields fall, mortgage rates usually decrease as well, as lenders don’t need to offer as much return to compete.

Economic Growth and Inflation Expectations

Both Treasury yields and mortgage rates are influenced by expectations of economic growth and inflation. When investors expect strong economic growth or higher inflation, Treasury yields increase because investors demand a higher return to offset the anticipated erosion of purchasing power. Mortgage rates rise along with Treasury yields under these conditions.

Fed’s Indirect Influence

The Fed can influence Treasury yields through monetary policy, such as adjusting the federal funds rate or engaging in bond-buying programs. However, Treasury yields, and therefore mortgage rates, ultimately depend on broader market dynamics, including economic conditions and investor sentiment.

Why Mortgage Rates May Not Fall When the Fed Cuts Rates

Even when the Fed cuts rates, mortgage rates may stay high or even rise if economic factors push Treasury yields up. For example, a strong economic outlook may lead investors to expect growth and inflation, which raises Treasury yields and keeps mortgage rates elevated.

Government policies, like tax cuts or increased spending, can push yields higher by raising deficits and economic activity. Tariffs, which Trump has proposed, can increase import costs and add to inflationary pressures, indirectly driving up both Treasury yields and mortgage rates.

Therefore, mortgage rates don’t follow the Fed directly but instead move in response to Treasury yields, which are shaped by economic expectations, market demand, and fiscal policy. Even if the Fed cuts rates to encourage borrowing, strong growth or inflation expectations can keep Treasury yields, and therefore mortgage rates, high. Mortgage rates are ultimately determined by a combination of market forces and economic outlook, not just the Fed’s rate cuts.