Instead of cutting rates, what if the Federal Reserve raises them?

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What if, instead of cutting rates three times this year to help a decelerating economy achieve a “soft landing,” Federal Reserve policymakers instead see inflation continue to run hotter than they would like and end up raising rates instead?

It’s not their base case, but if that “no landing” scenario becomes reality, it could send mortgage rates soaring above 8 percent next year and put stock markets into a tailspin, analysts at UBS Group AG said this week.

“If the expansion remains resilient and inflation gets stuck at 2.5 percent or higher, there would be real risk the [Fed] resumes raising rates again by early next year,” UBS strategists, including Jonathan Pingle and Bhanu Baweja, said in a note to clients.

UBS, which had previously expected the Fed to cut rates by 2.75 percentage points this year, is now projecting just two 25 basis-point cuts totaling a paltry half a percentage point, Bloomberg News reported.

That’s UBS’ baseline scenario. The worst-case scenario is that inflation keeps defying expectations, and the Fed instead raises rates by a full percentage point, bringing the federal funds short-term borrowing rate to 6.5 percent by mid-2025.

Just the chance of a Fed rate hike can have a meaningful impact on lenders and stock market investors, regardless of whether it actually happens, Michael Contopoulos, director of fixed income at Richard Bernstein Advisors, told Yahoo Finance.

“I put the odds as not so much that I think they will hike, as much as I think that the market will start to price in some probability of a hike,” Contopoulos said.

For now, futures markets still think the odds that the Fed will raise rates instead of cut them are nil. The CME FedWatch Tool, which tracks investor sentiment to gauge the probability of future Fed moves, on Monday put the odds that the federal funds rate will be higher in June 2025 at 0 percent.

Investors were pricing in less than a 2 percent chance that Fed policymakers will still be maintaining their current federal funds target rate of 5.25 to 5.50 in June 2025, and a 98 percent chance of one or more rate cuts.

But with inflation data continuing to come in hot, futures market investors now put the odds of one or more Fed rate cuts by this June at just 22.5 percent, down from 59 percent a month ago.

In the meantime, mortgage rates have already reclaimed much of the territory ceded last year by bond market investors who fund most home loans.

After falling from a 2023 peak of 7.83 percent registered on Oct. 25 to a 2024 low of 6.50 percent on Feb. 1, rates on 30-year fixed-rate loans climbed back above 7 percent last week, according to loan lock data tracked by Optimal Blue.

Mortgage rates are likely to continue to rise this week, with 10-year Treasury yields spiking by 13 basis points Monday following the release of stronger than expected March retail and food services sales data.

After adjusting for seasonal variation but not inflationary price increases, retail and food services sales were up 0.7 percent from February to March and 4 percent from a year ago to $709.6 billion, the Census Bureau reported.

Dip in ’30-10 spread’ a silver lining

Source: Optimal Blue and Federal Reserve data retrieved from FRED, Federal Reserve Bank of St. Louis.

While 10-year Treasury yields are a useful barometer for where mortgage rates could be headed next, one piece of good news for those concerned about higher borrowing costs for homeowners is that the “30-10 spread” between mortgage rates and 10-year Treasury notes has eased.

The spread, which averaged two percentage points before the pandemic, spiked above three percentage points at times last year as investors demanded higher returns on mortgage-backed securities (MBS) compared to Treasurys.

Part of the growth in the 30-10 spread was that, with the Fed expected to cut rates in 2024, MBS investors started demanding higher returns to compensate them for the increased prepayment risk posed by borrowers when they’re more likely to refinance.

In the hopes of providing relief to mortgage borrowers, last year real estate and lending industry groups pleaded with the Fed to stop winding down its massive MBS portfolio to reduce the spread. Instead of letting $35 billion in MBS roll off its books each month, the Fed could purchase new mortgages to replace maturing assets, the groups said.

After the Fed’s last meeting, Powell said that the central bank is preparing to slow the pace of its balance sheet “quantitative tightening.” But because mortgage rates are still too high to give homeowners much incentive to refinance, the Fed has only been able to trim its MBS holdings by about $15 billion a month, less than half of its $35 billion monthly target.

However, with fading expectations for big Fed rate cuts, the 30-10 spread has already been shrinking. The spread, which averaged 2.87 percentage points last year and 2.58 percentage points this year, has dipped below 2.50 percentage points twice in April — a threshold not breached since June 2022.

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