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Add the prospect of potential downgrades of America’s AAA credit ratings to the list of factors that could continue to push mortgage rates up next year.
Rating agency Morningstar DBRS is keeping a close eye on whether politicians in the nation’s increasingly polarized Capitol will be able to tackle fiscal challenges like the rising national debt, looming debt ceiling and inflation.
Nichola James
“We were expecting that there would be some checks and balances that would prevent some of the policies that could be perceived as creating even more fiscal pressures, but that’s now not the case,” Nichola James, managing director for global sovereign ratings at Morningstar DBRS told Reuters Thursday.
Although the Federal Reserve has cut short-term interest rates twice this year — on Sept. 18 and Nov. 7 — mortgage rates and yields on government debt have been on the rise, as bond market investors worry that inflation may not be licked.
“Bond vigilantes” — and many economists — believe tariffs, tax cuts and deportations proposed by President-elect Donald Trump will fuel inflation and add to the U.S. debt.
Downgrades of U.S. credit ratings by ratings agencies DBRS, Fitch Ratings, Moody’s Investors Service or Standard & Poor’s could fuel those concerns, leading investors to demand higher yields on government debt and mortgage-backed securities.
DBRS last year confirmed its AAA U.S. debt ratings last summer as “stable.” But the rating agency said it was monitoring “how political polarization could adversely affect U.S. credit fundamentals over time.”
Moody’s last November changed its outlook on its Aaa U.S. debt rating — the highest rating it assigns, to assets with “minimal credit risk” — from “stable” to negative, citing concerns about rising U.S. debt and interest rates on that debt.
“In the context of higher interest rates, without effective fiscal policy measures to reduce government spending or increase revenues, Moody’s expects that the U.S.’ fiscal deficits will remain very large, significantly weakening debt affordability,” Moody’s analysts said. “Continued political polarization within [the] U.S. Congress raises the risk that successive governments will not be able to reach consensus on a fiscal plan to slow the decline in debt affordability.”
Analysts at S&P Global Ratings on March 27 affirmed their AA+ long-term and A-1+ short-term unsolicited sovereign credit ratings on the U.S. as “stable” but said they’d be keeping a close eye on the election.
“This year’s national elections include not just the presidency, but also one-third of the Senate and the entire House of Representatives,” analysts at S&P Global Ratings said. “Whatever the outcome of the presidential election, the composition of Congress will continue to play a key role in determining policy outcomes. Policy outcomes are the main driver of creditworthiness.”
Federal debt approaching $35 trillion
Federal debt has risen by 50 percent since the beginning of the pandemic, from $23.2 trillion in Q1 2020 to $34.8 trillion as of June 30, 2024, according to the Department of the Treasury.
Another way to think about that debt is how it compares to the size of the U.S. economy. In the 1970s and early 1980s, federal government debt represented less than 40 percent of U.S. gross domestic product (GDP).
Government debt surpassed GDP in 2012 and escalated to an all-time high of 133 percent during Q2 2020 as the pandemic slowed economic output and government borrowing soared. Government debt as a percentage of GDP has since retreated to 120 percent as of June 30, but that’s still higher than it was in 1946 after World War II.
The cost of servicing that debt goes up when bond market investors demand higher yields. When government borrowing climbed at the outset of the pandemic, the interest payments on that debt rose more gradually, as long-term interest rates dropped to historic lows.
Interest payments on government debt hit $1T
But now that both government debt and long-term interest rates are rising, annual federal government expenditures to cover interest payments have risen from a seasonally adjusted annual rate of $508 billion in Q3 2020 to well over $1 trillion a year today.
While federal deficits and the rising national debt are longstanding and ongoing issues, the crises that can arise when Congress refuses to raise the debt ceiling can send interest rates soaring.
Worries that the U.S. might default on its debt helped push mortgage rates higher on two occasions last year, when negotiators took until the last minute to reach deals to raise the debt ceiling.
“The brinkmanship over the debt ceiling, failure of the U.S. authorities to meaningfully tackle medium-term fiscal challenges that will lead to rising budget deficits and a growing debt burden signal downside risks to U.S. creditworthiness,” analysts at Fitch Ratings said in placing their AAA U.S. long-term foreign-currency issuer default rating on rating watch negative last May.
Fitch Ratings ended up downgrading that rating to AA+, reaffirming it as “stable” on Aug. 29.
But the current suspension of the debt ceiling is set to expire in January, and Fitch analysts said they believe that “similar to 2023, extraordinary measures and the cash balances will last several months before the deadline known as the x-date is reached.”
Tax cuts that were signed into law by Trump in 2017 are set to expire at the end of next year and “will be a key policy discussion next year,” Fitch analysts said.
Rising government debt, inflation and debt ceiling crises can all impact mortgage rates because most home loans are funded by mortgage-backed securities (MBS).
Because payments to investors who buy most MBSs are backed by mortgage giants Fannie Mae, Freddie Mac and Ginnie Mae, they’re seen by investors as a similar, if slightly more risky, proposition than 10-year Treasury notes.
Odeta Kushi
“Investor expectation of the Fed’s first rate cut in September quickly put downward pressure on mortgage rates, as investors bullishly, and perhaps prematurely, anticipated lower inflation and further rate cuts,” First American Deputy Chief Economist Odeta Kushi wrote Thursday.
“Since then, upwardly revised economic data, including strong employment numbers, and the election have lowered bond market expectations for future rate cuts relative to the Fed’s current projections, pushing the 10-year Treasury yield up from its September low. This increase has, in turn, driven mortgage rates higher.”
Rates on conforming 30-year fixed-rate mortgages backed by Fannie Mae and Freddie Mac track 10-year Treasury yields closely, although the “spread” between them can vary.
Wider 30-10 spread
The 30-10 spread — the gap between rates on 30-year fixed-rate mortgages and 10-year Treasury yields, depicted in green — has widened in recent years.
Although the Fed doesn’t have direct control over long-term interest rates, it’s become a significant player in bond and MBS markets, buying trillions in government debt and mortgages to bring down borrowing costs during the 2007-09 Great Recession and pandemic.
Those debt purchases (“quantitative easing”) left the Fed with an $8.5 trillion balance sheet, which it’s been trying to trim (“quantitative tightening”) by letting maturing bonds and MBSs roll off its books.
Mortgage and real estate industry trade groups have complained that the Fed’s participation in bond and MBS markets has widened the “spread” between 10-year Treasurys and mortgage rates.
Last fall, when mortgage rates were nearing their post-pandemic peak, Mortgage Bankers Association CEO Bob Broeksmit made an appearance on CNBC pleading with Fed policymakers to “make clear that they’re not going to sell mortgage-backed securities off their balance sheets.”
Bob Broeksmit
But in a follow-up message to MBA members, Broeksmit said Fed policy alone “is not responsible for the recent rate instability,” noting that another brush with a government shutdown demonstrated Congress “must take steps to restore budget discipline and effective policymaking.”
The MBA, Broeksmit said at the time, “will continue to urge policymakers to stop the shutdown threats and come together to address budget and spending priorities that restore fiscal discipline.”
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