Thoughts on the Market

U.S. mortgage rates are hovering around their highest levels in three years. Morgan Stanley Co-Heads of Securitized Products Research Jay Bacow and James Egan examine the forces keeping homeowners locked in and buyers priced out of the housing market.
Read more insights from Morgan Stanley.

----- Transcript -----

Jay Bacow: Jim, [we’re] getting a lot of questions about mortgage rates. We've been flying across the country talking to people. Are your arms tired?
James Egan: I'm hoping that all the extra flapping will give them just a little bit more definition so we can show them off as we talk about adjustable-rate mortgages.
Jay Bacow: And that is the definition of an ARM. Welcome to Thoughts on the Market. I'm Jay Bacow, co-head of Securitized Products Research at Morgan Stanley.
James Egan: And I'm Jim Egan, the other co-head of Securitized Products Research at Morgan Stanley
Jay Bacow: Today, we're here to talk about mortgage rates: how quickly they've moved, why they're here, where they might go, and what it means for the mortgage and housing market.
It's Thursday, October 8th, at 9am in New York.
Jim, as of this recording, the 10-year is over 5.3 percent. Rates haven't closed this high since 2002. The 30-year mortgage rate is around 7.5 percent. It’s about 150 basis points up since the beginning of February.
James Egan: Right. There have been quick moves in rates that has led to quick moves in mortgage rates. There are a lot of implications to that – from affordability, the housing market, mortgage market.
But when we think about the relationship between mortgage rates and interest rates, Jay, there's also a feedback mechanism there. Convexity hedging is what it's typically called.
Can you discuss the role that that might have played in this current episode? And what we should expect going forward?
Jay Bacow: Sure. So, the biggest driver of mortgage rates is Treasury rates. And Treasury rates are driven by a number of factors, and right now most people would point to inflation expectations and geopolitical concerns.
However, as Treasury rates go higher, homeowners that currently have a mortgage are less likely to move. And because they're less likely to move, that means that the average life of those mortgages that investors own gets longer.
And because mortgage investors typically want to keep their duration profile constant – as the average life of those mortgages gets longer, they are then going to need to either sell those mortgages or sell Treasuries, which will cause yields to go even higher.
And there's a bit of a feedback loop on that, which can pressure yields and mortgage rates even higher.
But what we would say is, at this point, we don't think there's a huge mechanism of that going through at this rate level. The average mortgage rate that homeowners have in America is almost exactly 4.5 percent. Obviously, they're less likely to move as rates go up. But they're 300 basis points out of the money.
So, from that point, it matters. But it didn't matter as much as when rates were a little lower. However, Jim, 7.5 percent mortgage rate – what does this do for housing affordability? Can you put that in context?
James Egan: Yeah. So, if we just think about this in terms of what a 7.5 percent mortgage rate implies for the monthly payment on the median-priced home, we are now up over $325 dollars if we use that 7.5 percent – assuming home prices are where they are today, incomes are where they are today.
That monthly payment's up over $325 from where we are at local lows in February; or where we were at local lows in February. That's a 17 percent increase, in terms of that monthly payment over just a seven-month period.
Jay Bacow: Alright, so, 17 percent increase over a seven-month period, that's kind of scary.
But as you and I have talked about in the past, given the fixed rate nature of the U.S. mortgage market, it's a tad misleading for the average homeowner in America.
So, what does this do to sales? Obviously, it's scary for new homeowners, though.
James Egan: Right. Look, you brought up the implications from a duration perspective, a convexity hedging perspective. All of this is just how the lock-in effect continues to have material implications for the housing market, for mortgage markets.
But yes, these affordability issues – not that bad for homeowners who have an average rate below 4.5 percent. That's not changing. Over 90 percent of the balance or count of mortgages, depending on how you want to look at it, in the United States remains fixed rate. Their payments aren't changing, right?
But the marginal home buyer, things are getting less affordable. I don't like to use the term demand destruction. I think that sounds a little bit too over the top here. But like we are seeing some of our higher frequency or more leading indicator demand metrics show a little bit of softening here.
Pending home sales, past two months, 3 to 5 percent down year-over-year. Purchase applications, which had been very strong, in September, they were down about 10 percent year-over-year. So, look, we were seeing a little bit of demand increases this year. We were up about 2 percent year-to-date through July.
It's a small increase off of a very, very low base. But we think you're going to see with rates at these levels, if we maintain these levels, is effectively the probability or any real ability of the market to escape to the upside from an activity perspective? That probability keeps coming down. And we're going to be stuck in this turnover, very range-bound, lowest level of sales as a percentage of the housing market in 40 years.
Jay Bacow: So really low activity, what does that do to prices? Is there some flow through? Is there relief coming?
James Egan: Look, as demand softens, the kind of first-order expectation or the heuristic should be that prices should soften as well. But again, lock-in effect; what we've actually seen is the rate of growth for existing listings at these levels has slowed. And it's slowed pretty materially.
That's actually led to home price appreciation accelerating over the past few months. We've gone from just 0.7 or 0.8 percent four months ago to 1.9 percent for the data that we just received. We think that that level is kind of sustainable here, and we're going to be between like roughly 2 percent, give or take, for the remainder of this year.
Now, you and I have both been mentioning the lock-in effect throughout the course of this. Yes, an overwhelming majority of the market is fixed rate right now. But the media, our conversations with clients, there's been a lot of discussion of potentially a growing share of adjustable-rate mortgages to kind of help the marginal homeowner with affordability.
What are we seeing in ARMs right now?
Jay Bacow: Okay. Yeah, so great question, and we are seeing a pickup in ARM issuance. If we look at the percentage of mortgages that were ARMs through the first half of this year and compare them to the percentage of ARMs in the first half of last year, it's increased by about 1 percent on aggregate issuance. It's went from about a little over 15 percent to a little over 16 percent.
And so, 1 percent increase is not a huge number by itself, but when we're talking about a little over $2 trillion of expected issuance in the course of the year across the entire mortgage market, this does help on the margin. And we do think, as we said in the past, that more uptake of ARMs would likely be a little bit of a positive solution to some of the affordability challenges.
But Jim, if people take out more ARMs, recognizing that most people only have two arms, should we be worrying about a repeat of the financial crisis and lending standards?
James Egan: So, this is a question that we get a lot when we start talking about moving away from fixed-rate mortgages. And the point that I want to stress; that we want to stress here, is not all ARMs are created equal…
Jay Bacow: Mine are stronger than yours?
James Egan: Sure, we'll go with that. But also, if we control for borrower characteristics, right? Credit scores, loan-to-value ratios, debt-to-income ratios, right? And then we compare performance of adjustable-rate mortgages to fixed-rate mortgages, 7-1 ARMs, 10-1 ARMs, they perform very much like fixed-rate mortgages.
It's really the short-reset ARMs, what we'll call affordability products. So, they only have 24-month or 36-month fixed periods. Those are what have historically showed a much higher rate of default and something that would get us a little bit more concerned about lending standards if those were the products we're talking about.
Thankfully, they're not right now. The ARM growth that we're seeing is in the 5-1, 7-1, 10-1 space. Those have historically, again, controlling for borrower performance, performed like fixed-rate mortgages. And so, we think that you can expand mortgage product into ARMs and do it responsibly.
Jay Bacow: All right. Jim, always a pleasure speaking with you.
James Egan: And always great speaking to you too, Jay. And to all of our regular listeners out there, thank you for adding us to your playlist. Let us know what you think wherever you get this podcast, and share Thoughts on the Market with a friend or colleague today.
Jay Bacow: Go smash that subscribe button.

The AI investment boom has been a defining force in markets. Our Head of Public Policy Research Ariana Salvatore looks at whether the U.S. midterm elections could change the spending and policies behind it.
Read more insights from Morgan Stanley.

----- Transcript -----

Ariana Salvatore: Welcome to Thoughts on the Market. I'm Ariana Salvatore, Head of Public Policy Research at Morgan Stanley.
Today, what the midterms could mean for the AI investment cycle.
It's Wednesday, October 7th at 10am in New York.
I've spoken on this podcast before about the broader implications of the midterm elections.
This time, I want to go a little deeper on what they could mean specifically for AI sentiment.
We think about that through two separate channels. The first is data center opposition, where we do think the elections can be an important catalyst. The second is broader AI safety and regulation, where we think the election outcome matters much less.
And that distinction is important. It suggests that the midterms are more likely to influence investor confidence in the pace and the durability of AI infrastructure spending, rather than fundamentally rewriting the rules governing AI.
Let's start with data centers. Our base case is still a conditional build-out. We still expect substantial AI infrastructure investment, but increasingly subject to conditions around things like power costs, grid investment, siting, permitting, water use, and community impact. We don't expect a broad federal pause on data center development.
AI compute is increasingly being viewed in Washington as strategic infrastructure, particularly when you consider competition with China. So, we think that national security framing should remain supportive of the build-out.
But here's the important point for these elections. Many of the policy levers that can actually delay a project sit well below the federal level. Think about things like interconnection approvals, large load electricity tariffs, zoning, water permits, and tax abatements. Those are all generally controlled by states, utility commissions, and local governments.
So, when it comes to AI infrastructure, we actually think governors, state legislatures, and public utility commissions may ultimately matter more than control of any one Senate seat in particular.
And that brings us to sentiment.
At the federal level, we think a Republican sweep would likely be the most constructive outcome for AI infrastructure sentiment. Now, that's because investors would likely expect fewer regulatory constraints ahead. As well as a greater likelihood of active support for permitting reform, additional power generation, and development on federal land.
A divided government outcome, we think, looks closer to the status quo. It would preserve questions about the durability of the build-out, but the gridlock in D.C. would also leave many of the substantive decisions at the state and local level.
And lastly, we think a Democratic sweep would be the least constructive outcome for sentiment. Now, importantly, that doesn't mean that we expect a nationwide data center moratorium, as I said. Rather, investors could interpret Democratic outperformance as increasing the probability of tighter local restrictions in the near term, and potentially much more federal scrutiny after the next 2028 elections.
So that's the infrastructure side. What about AI regulation more broadly? Here, we think the midterms are actually much less consequential. Our expectation remains for incremental and fragmented regulation rather than a sweeping new federal regime.
AI safety, data governance, and frontier model oversight, we think can certainly see targeted action. But we just don't think congressional composition by itself is likely to trigger comprehensive legislation – unless there's a sufficiently high-profile safety or security incident. Executive agencies are also likely to remain the more important actors on tech restrictions and model access.
And that gets us to the main takeaway for investors. The midterms probably won't determine whether the AI investment cycle continues. We think the strategic case for expanding U.S. compute capacity remains intact.
What they can influence, however, is the friction around that build-out. Where the projects get built, how quickly they receive approval? Who bears the cost? And ultimately, how confident investors are in the durability of AI CapEx?
So, when we think about what happens in November through an AI lens, we'll be watching D.C. But in many cases, the more important signals can come from governors' races, utility commissions, and local elections – because that's where the politics of AI are increasingly meeting the physical constraints of actually building it.
Thanks for listening. If you enjoy the show, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

Our Japan Financials Analyst Mia Nagasaka explains why a once-in-30-year investment cycle could transform corporate financing and open a new chapter for Japanese banks.
Read more insights from Morgan Stanley.

----- Transcript -----

Welcome to Thoughts on the Market. I’m Mia Nagasaka, Head of Japan Financials Research at Morgan Stanley MUFG Securities.
Today – a once-in-30-year investment cycle is changing how investors think about Japanese banks.
It’s Tuesday, October 6th, at 10am in Tokyo.
For decades, Japanese companies had more cash than investment opportunities. But now it's changing.
This marks a new chapter for Japanese banks. The first stage of recovery was largely about interest rates. As Japan moved away from negative rates, higher lending yields helped bank margins and earnings.
This next stage is about growth in the banking business itself, driven by companies investing more and needing more external capital.
In fact, we think Japan is entering its first meaningful capex cycle in nearly three decades. Investment needs are broadening, from labor-saving technology to the replacement of aging equipment. Companies are also becoming more active in reallocating capital toward businesses where they see stronger returns.
For banks, the most direct opportunity is lending. We expect Japan’s domestic loan market to grow from about 588 trillion yen, or roughly 3.7 trillion U.S. dollars, in the fiscal year ending March 2026 to roughly 712 trillion yen, or about 4.5 trillion dollars, by March 2031. Loan growth could run at around 5 percent annually early in the investment cycle, then settle at about 3 to 4 percent.
And the financing opportunity extends beyond loans. Take Japan’s debt capital markets, where companies raise money by issuing bonds. We expect them to grow from about 52 trillion yen, or roughly 331billion dollars, to 63 trillion yen, or about 401 billion dollars, by March 2031. We also forecast the M&A market to rise from 23 trillion yen, or roughly 146 billion dollars, to 32 trillion yen, or about 204 billion dollars, over the same period. Large projects often need several forms of financing, so lending can open the door to underwriting and advisory fees as well.
This gives banks more ways to generate earnings. In the early phase, banks can benefit mainly from lending and project finance. As projects mature, fee-based businesses such as capital markets and M&A can contribute more. This makes the opportunity look less like a short-lived lending boom and more like a multi-stage financing cycle.
The key measure to watch is return on equity, which shows how effectively a bank turns shareholder capital into profit. Japan’s megabanks are currently generating ROEs of roughly 10 to 11 percent. We see a path toward around 15 percent over the medium term. Structural growth in corporate financing demand alone could add about 1 to 1.5 percentage points.
So, the bigger story is not simply that rates have risen. Japan may be moving from an economy defined by excess savings and underinvestment toward one where companies need capital to grow. If that transition continues, banks could have substantially more productive opportunities to deploy their balance sheets.
Thanks for listening. If you enjoy the show, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

Recent headlines about Canada have focused on trade uncertainty and weak productivity. But our Global Economist Arunima Sinha explains why the country may be on the cusp of a stronger, investment-led growth cycle.
Read more insights from Morgan Stanley.

----- Transcript -----

Arunima Sinha: Welcome to Thoughts on the Market. I'm Arunima Sinha from Morgan Stanley's Global and U.S. Economics teams.
Today, why Canada's economy may be closer to a new growth phase.
It's Monday, October 5th at 10am in New York.
Canada has been in the news recently. There have been lots of headlines related to trade, around population growth, around weak productivity, years of underinvestment. And those are real constraints, and they have weighed on the near-term outlook.
At Morgan Stanley, we are more constructive on the medium-term outlook for Canada. And we recently wrote a report around this along with our strategists titled, “Canada: The Next Acceleration.” And, from our perspective, we think that the near-term uncertainty around trade is actually clouding the opportunity for global investors.
There are three points that we make in the report.
We estimate that the growth model in Canada over the next three to four years can actually pivot from the export-led growth story that we've seen over the past few years into one that emphasizes capital deepening and greater technological diffusion across the economy.
So, it really is about the domestic build-out and the opportunity in shifting away from trade and export-led growth into a more productive economy – that's not just larger over time but can actually grow at a much faster pace as well. And so, by our estimates, we think that potential growth in Canada could feasibly rise from about 1.5 percent to closer to 1.75 percent.
The way that we see it, this really doesn't require things to start from scratch. There are already large capital pipelines that are in place. But one of the things that we do note is that a lot of these pipelines are actually concentrated in a few sectors.
So, about half of these are in utilities and oil and gas, transportation. These sectors together combine about 13 to 14 percent of the gross value add for the economy. But they actually account for more than half of the announced capital pipelines. And so, for the money that's going into the economy – and a lot of this is going into structures – it's not going as much into machinery and equipment.
And so, while the capital build-out is going to support the widening, we also need to think about crowding in private investment into other sectors. And some of these other sectors that we've identified in the note, such as finance, information services, that have historically had much greater gains in productivity – they would need to see bigger capital intentions as well.
The other opportunity that we identify for the Canadian growth model is – although the near-term population growth has been slowing, it doesn't actually change the longer run demographic picture. We looked at what the numbers would be for the working age population growth for Canada, taking 2025 as a starting point. And what we see is that Canadian working age population is going to rise by about 3 percent by 2035, by 5 percent by 2040, and 6 percent by 2045.
Meanwhile, most of the developed economy peers are going to see shrinkage in their working age populations. And so that is really going to give Canada a window into the rest of the 2030s to continue to accelerate its growth model.
From our perspective, the test for the next few years is going to be whether the investment that's being undertaken in a few sectors spreads beyond the big projects. And it really lifts productivity across the economy. Construction, manufacturing, agriculture, and wholesale will be especially important because they are machinery intensive, technology adoption remains low, and recent productivity gaps are large.
If those sectors begin to improve, Canada could enter the 2030s with a much stronger growth engine than it has today. And in our perspective, Canada's potential growth could actually pivot from being about 1.5 percent today to entering the 2030s with close to 2 percent in potential output growth.
Thanks for listening. If you enjoy the show, please leave us a review wherever you listen and share our Thoughts on the Market with a friend or colleague today.

Our Global Head of Fixed Income Research Andrew Sheets examines what rising rates could mean for equity valuations, earnings and investor appetite.
Read more insights from Morgan Stanley.

----- Transcript -----

Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Fixed Income Research at Morgan Stanley.
Today, thinking about equity resilience in the face of rising bond yields.
It's Friday, October 2nd at 2pm in London.
The benchmark U.S. 10-year Treasury yield has risen about 100 basis points this year. Global equities, at the same time, are up about 13 percent. And those two facts sit in an uncomfortable tension.
After all, higher bond yields give investors better return options elsewhere, and they also make future corporate profits worth less today, which in theory should push stock prices lower.
But there's a wrinkle here.
That valuation theory actually has two moving parts. What we're referring to here is what we would call a dividend discount model or a Gordon Growth Model, where the value of a company today is worth the value of its dividends divided by the difference of its required rate of return and its growth rate.
The higher the required rate of return, which interest rates push up, hurts a stock valuation. It increases the denominator. But a higher growth rate, well, that works in the opposite direction. That decreases the denominator. It makes the company worth more.
Hopefully, this is intuitive. if a company has to meet a higher return hurdle, it will be worth less today. If a company's growing faster, all else equal, it's worth more. And that, we think, goes a long way to actually explain what's going on in markets today. Because corporate profits are growing quickly.
Over the last year, profits for the S&P 500 are up about 30 percent, and the earnings growth for the median company, well, that's still up in the mid-teens. Growth in Europe, Asia, and emerging markets have also been historically strong.
Indeed, if you'd told me on January 1st that the S&P 500 would be up about 13 percent, and at the same time, U.S. Treasury yields would be up about 100 basis points, I probably would have told you with reasonable confidence that stocks would look more expensive relative to bonds.
But they don't. The valuation of the equity market, the P/E ratio, has fallen significantly as yields have risen. But because earnings have risen so much more, stocks are still higher. And the so-called equity risk premium, the difference between the earnings yield and the bond yield, it's pretty stable year to date.
Now there's another way that higher yields could hurt the stock market. They could simply cause people to sell their stocks and buy those higher yielding bonds. But so far, we're not seeing evidence of that. The flows that we track continue to show money flowing into both stocks and bonds.
And the two markets are moving in the same direction day to day. They're showing positive correlation, which is not the outcome you'd expect if people were shifting money from one to the other.
There's also an interesting way that companies have a say in this debate. Investors every day look at the market and decide if these yields are high enough that they want to buy them. But companies look at the same yield and say, "Is this low enough that we would want to sell?" And so especially for the companies that are funding the AI build-out – these large technology companies with so much AI spending to do. Many of them, even at these higher yields, are still saying these are attractive levels to issue at. And are more attractive than, say, issuing more stock.
The other factor that's always important to keep in mind whenever we're debating long-term valuation questions between stocks and bonds, or really any asset class, is that valuation is a slow-moving force. It is often not terribly predictive of the next six or even 12 months. Indeed, if we think about the difference between the earnings yield on the equity market, the inverse of the P/E ratio, and what the bond market yields, that difference. Well, that difference only explains about 10 percent of returns between stocks and bonds over the next month.
Now, valuation is more powerful the longer you give it. And so, extend that horizon out over the next three years and that valuation gap between bonds and equities, well, explains about half the three-year outcome.
Markets are not equations that are solved once a quarter. They are ongoing arguments about the future. And when growth is strong, investors are simply more willing to give growth and that future potential the benefit of the doubt.
We think this goes a long way to helping to explain the equity market's resilience despite Treasury yields moving well above five percent. But it's also raising the bar.
Higher yields simply leave less room for earnings disappointment. Those profits need to keep growing quickly.
Thank you, as always, for your time. If you find Thoughts on the Market useful, let us know by leaving a review wherever you listen. And also tell a friend or colleague about us today.