The Truth About Fed Rate Cuts
The Federal Reserve has been on a rate cutting rampage and many mortgage applicants are calling their mortgage representative expecting a lower interest rate. Others who have been waiting to refinance are puzzled as to why mortgage rates have not moved lower during the recent six Fed rate cuts. In fact mortgage rates are now higher than they were before the Fed began cutting rates back in September. This is difficult to explain to many consumers who have watched a 3.25% reduction by the Fed with little or no benefit in mortgage rates. Is a Fed rate cut really good news for mortgage rates?
The facts may be surprising.
The Fed only has control over the “Discount Rate” and the “Fed Funds” Rate. The Discount Rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility. The Fed Funds rate is the rate banks charge one another for overnight loans to keep their balance sheets in line with institutional requirements. These rates affect auto loans, credit cards and home equity loans so as you can see this is very different from mortgage rates. A mortgage rate can be in effect for 30 years whereas a rate that is set by the Fed can change from one day to another.
Another common mistake is in thinking that 30-year Treasury Bonds or 10-year Treasury Notes are directly pegged to mortgage rates. Those are government securities that are backed by the full faith and credit of the U.S. government and have no direct effect on mortgage rates. In fact, on March 11 the 10-Year Treasury Note LOST 103 points while mortgage rates actually showed a slight improvement. As we stated in our previous article Shopping Around, if you’re working with a lender that’s following the daily performance of Treasury Bonds or Notes, then you might just as well throw darts at a board to tell you where mortgage rates are headed.
So what are mortgage rates based on?
As it turns out the answer is mortgage-backed bonds known as Mortgage Backed Securities (MBS). Bonds issued by Fannie Mae and Freddie Mac and the trading performance of those bonds will determine the direction of mortgage rates. So finding the catalyst that causes mortgage bonds to move will give you the keys to finding out what makes mortgage rates rise or fall. (Fannie Mae and Freddie Mac are what’s known as “Government Sponsored Entities” that are charged with securitizing large pools of mortgages from lenders and then selling those securities to investors. The purchase of these mortgage backed securities provides the funds that lenders will use to make loans to their future mortgage borrowers.)
We know that inflation will always be a negative for any long-term bond because it eats away at the future returns. Here's an example. Let’s say a pension fund decides to invest some of the millions of dollars they’re holding into a bond with a 6% fixed rate of return. With the cost of gasoline, food and just about everything else going up, let’s also say that inflation is hovering around 4%. Well, that 6% bond is now only going to yield a net return of 2% on their investment after allowing for 4% inflation. And since Fed rate cuts pump more money into the economy which fans the inflation fires, investors tend to pull their money out of bonds and park it into stocks almost every time a new rate cut is announced. This forces bond traders to reduce the selling price of a bond and raise the interest rate, or “yield”, a bond will pay in an effort to get those investors to come back. The money to pay those higher yields on mortgage bonds has to come from somewhere and you guessed it. It comes from mortgage borrowers in the form of higher mortgage rates! Conversely, when the Fed raises rates, bond investors know this will help reduce inflation so they bail out of stocks and put those dollars back into bonds.
Here’s a look at how the most recent 6 Fed cuts affected mortgage rates:
September 18, 2007: Fed cuts .500% / mortgage rates increase .250% over the next 2 days.
October 31, 2007: Fed cuts .250% / mortgage rates increase .125% over the next 5 days.
December 11, 2007: Fed cuts .250% / mortgage rates increase .125% over the next 2 days.
January 22, 2008: Fed cuts .750% / mortgage rates increase .375% over the next 3 days.
January 30, 2008: Fed cuts .500% / mortgage rates increase .250% over the next 3 days.
March 18, 2008: Fed cuts .750% / mortgage rates increase .250% within 1 day.
Now we all know that these mortgage rate increases have not been cumulative or 30-Year fixed mortgages would be well over 7% today. This is because when stocks are out of favor, which is usually due to bad economic news, investors will do just the opposite of what we explained above. They’ll pull money out of stocks and seek the safe haven of bonds which then INCREASES a bond’s selling price and REDUCES its yield (remember the old rule of supply and demand...if everybody wants something, the price will go up). And if you’ve been following the news these past few months, you know the markets have been tremendously volatile. So the fact that mortgage rates typically climb every time the Fed makes a cut doesn’t mean they won’t come back down.
When you’re shopping for a mortgage, timing is everything so it’s critical to know the relationship between Fed cuts and mortgage rates. Otherwise you’ll be one of the many consumers who missed the opportunity to obtain a lower rate because you mistakenly waited for the anticipated Fed action to cut short-term rates, thinking that longer-term mortgage rates would decline as a result. So the next time someone tells you the Fed is going to lower interest rates, you’ll know that mortgage bond prices are likely to deteriorate and mortgage rates are probably going to go up.
Predicting the future is tough, so nothing is written in stone. And though the best rates may be behind us for a while, mortgage rates are still low and could have some quick dips. The trick is to know what influences them and how.
We don’t expect you to remember everything we’ve explained here, but a good summary would be what’s good for stocks is usually bad for bonds and mortgage rates. And since the Fed uses rate cuts to stimulate the economy which is good news for stocks, it has the opposite effect on bonds.
