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Fed Rate Cuts Do Not Equal Lower Mortgage Rates

The Federal Reserve has cut the short term interest rate for the sixth time.  Many mortgage applicants are calling their mortgage representative expecting a reduction in the long term interest rate. Others who have been waiting to refinance are puzzled as to why mortgage rates have not moved lower during the recent Fed rate cuts. In fact mortgage rates are now higher than they were before the Fed began cutting rates last September. This is difficult to explain to many consumers who have watched a 3% reduction in the prime lending rate with no benefit to long term mortgage rates.

Is a Fed rate cut really good news for mortgage rates? The facts may be surprising. The Fed can only control the Discount Rate, the rate the Fed charges banks on borrowed funds and the Fed Funds Rate, the rate banks charge each other on borrowed funds. This is very different from mortgage rates. A mortgage rate can be in effect for 30-years, a rate that is set by the Fed can change from one day to another.

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 (MBS) and the trading performance of those bonds will determine the direction of mortgage rates. Finding the catalyst that causes mortgage bonds to move will give you the keys to finding out what makes mortgage rates rise or fall.

We know that inflation will always be a negative for any long-term bond because it eats away at the future returns. Since the bond will pay a set amount over a long period of time, that amount will be less valuable as inflation rises. One catalyst that moves in the opposite direction of MBS prices is the Stock Market.

As the Stock Market moves higher, bond prices move lower causing interest rates to rise. As the Stock Market declines, mortgage bonds benefit, causing mortgage rates to fall. Additionally, and unlike common opinion, Fed rate cuts have had virtually no direct effect on mortgage rates. Moreover, it appears that since Fed rate cuts act to stimulate the economy and thus the Stock Market, they have a negative effect on mortgage rates.

This will ultimately influence the direction of mortgage rates, because money managers and mutual fund companies typically keep funds in either stocks or bonds with very little in cash. If stocks are in favor, money is pulled from bonds, causing bond prices to drop and interest rates to rise. When stocks are being sold off, the money is then parked into bonds, which improves bond prices and causes interest rates to decline.

A closer look at the 6 rate cuts by the Fed this year shows that mortgage bond prices deteriorated after each Fed rate cut. This means that mortgage rates rose after the Fed had cut rates while many consumers were expecting mortgage rates to decline.

orse yet are the consumers who missed the opportunity to obtain a lower rate because they mistakenly waited for the anticipated Fed action to cut short-term rates, thinking that longer-term mortgage rates would decline as a result.

Predicting the future is tough.  Mortgage rates are still low and could have some quick dips so make the most of them while they last.

Recession and Interest Rates. What will happen?

Should the economy continue to deteriorate, the Fed – and financial markets in general – will push interest rates lower. What signs does the Federal Reserve look at?  What signs are we looking for?  Employment, Inflation and Gross Domestic Product are the three components the Fed uses to determine economic health.  Slowing employment growth is a key problem that would worry the Fed.  A slowing economy which would be reflected in a decline among stocks would be important as well. But the most important component would be a retrenching American consumer. Lower rates would, of course, enable many to do needed refinancing to get out of onerous existing mortgages.  It would also help many potential homebuyers.

We are likely to remain in somewhat of a credit crunch, even if rates come down further, because there is far less money available for the funding of mortgages. Lower rates can have another effect as well. Investors become hungry for a better yield. That, frankly, is one of the main reasons we are in the mess we are in. It is doubtful that such a problem could develop again anytime soon. Instead it is more likely that the mortgage industry would accelerate its development of new programs that could make lower interest rates more attractive than they would otherwise be.