There has been a lot of discussion about interest rates recently and a general lack of knowledge about what is driving mortgage rates to go up so I wanted to make a post outlining the reasons why mortgage rates have continued rising and will continue to rise until inflation decreases to about 6% (reduced from the current trend of 12.7% in April). 

The average mortgage rate is currently at 5.78% for a 30 year fixed (FannieMae). In theory, this rate should have all future expectations baked into the price, but I am making the case below that this is not true. 

[skip to the bottom for the impact to investors]

Here is why, 

1. Higher inflation drives interest rates up and inflation expectations are increasing. 

Why does inflation matter?
The way to decrease inflation is to increase interest rates on debt, which reduces the total amount of cash in the system and decreases the amount of dollars chasing goods and services thus decreases inflation (see here for explanation). So increasing inflation leads the Fed to increase interest rates. 

Every month the Federal Reserve has adjusted their inflation expectations upward - like clockwork. This is more likely to continue than to reverse, especially as energy costs continue to push prices upward in the summer. The Fed under-estimates inflation so as to avoid a self full-filling prophecy. This leads to manipulated mortgages rates, which are too low and will eventually be corrected by the free market if the Fed stops buying mortgages. 

2. The Fed is selling off it's $2.7 Trillion of MBS (source) and the private market for mortgages will likely require larger interest rates because they cannot print money like the Fed. We no longer know what the real market rate for mortgages is but we will soon find out and it will most likely return to historical levels, which are higher than today. 

3. The real interest rate for all types of debt is still negative (this is calculated by subtracting inflation from the interest rate). This is unsustainable and violates the basic principals of economics. Eventually inflation must come down or interest rates must come up.  

Until the real real mortgage rate returns to a positive level, the Fed will be required to raise rates to keep inflation under control. If they do not, inflation will spiral out of control. 

Of course, inflation could decrease and return to more "normal" levels. Especially if The War in Ukraine stops, oil in the US becomes cheaper and/or the economy slows down significantly. 

So what does this mean for investors?

1. With the mortgage payment increasing, the number of deals that provide a positive return on capital will decrease.

2. The cap rate for properties will likely increase, which means cash investors will actually achieve greater returns (everything held constant) .

3. The risk to investors with floating interest rates is very high if inflation continues upward. If inflation decreases, then we can expect interest rates to come down as well. 

Do you agree or disagree? Let me know in the comments : )