Ever wonder why mortgage interest rates sometimes don’t decrease when the Federal Reserve cuts interest rates and vice versa? The simple answer is that the Fed does not control mortgage interest rates.
Instead, the Federal Reserve controls the Fed Funds Rate (FFR), which is an overnight interbank lending rate. An overnight rate is the shortest lending term, which means shorter duration lending rates such as credit card interest rates and short-term car loan interest rates will be affected.
However, mortgage rates have longer duration lending terms. Therefore, longer duration U.S. Treasury bond yields have a far greater influence on mortgage interest rates than the FFR.
The Fed Doesn’t Control Mortgage Rates
After the Federal Reserve slashed its Fed Funds Rate to 0% – 0.25%, mortgage rates actually went up because US Treasury bond yields went up by ~0.5%.
The increase came about partly as a result of Congress’ approval of a major spending package aimed at curbing the economic impact of the coronavirus, as well as discussions of a broader, more expensive stimulus package now known as the CARES Act.
The plan will require a large amount of government debt to be issued, in the form of U.S. Treasuries. Knowing that more bonds will be in the market, current Treasuries suddenly warranted lower prices, which resulted in higher yields.
Mortgage rates and Treasury bond yields also went up after the emergency rate cut because of the negative signaling by the Fed. If the Fed couldn’t wait three days to cut rates during its policy meeting, then things must be really bad. As a result, investors indiscriminately sold everything to raise cash.
Finally, mortgage rates went higher after the Fed cut the FFR due to expectations for higher prepayments which degrades investor returns and creates high gross supply of Mortgage Backed Securities.
The Federal Funds Rate is the interest rate everybody is referring to when discussing cutting or increasing interest rates. The FFR is the interest rate that banks use to lend to each other, not to you or me.
There’s generally a minimum reserve requirement ratio a bank must keep with the Federal Reserve or in the vaults of their bank, e.g. 10% of all deposits must be held in reserves. Banks need a minimum amount in reserves to operate, much like how we need a minimum amount in our checking accounts to pay our bills. At the same time, banks are looking to profit by lending out as much money as possible at a spread (net interest margin).
If a bank has a surplus over its minimum reserve requirement ratio, it can lend money at the effective FFR to other banks with a deficit and vice versa. A lower effective FFR rate should induce more inter-bank borrowing which will be re-lent to consumers and businesses to help keep the economy liquid.
This is exactly the outcome the Federal Reserve had hoped for when it started to lower interest rates in September 2007 as the economy began to head into a recession.
Study the historical Effective Federal Funds Rate chart below.
By the summer of 2008, everybody was freaking out because Bear Sterns had been sold for a pittance to JP Morgan Chase. And then on September 15, 2008, Lehman Brothers filed for bankruptcy. Nobody expected the government to let Lehman Brothers go under. But when it did, however, that’s when the real panic began.
What happens when everybody freaks out? Banks stop lending and people stop borrowing. This is what economists call “a crisis of confidence.” Consequently, the Federal Reserve lowered the FFR in order to compel banks to keep funds flowing. Think of the Federal Reserve as attempting to keep the oil flowing through a sputtering car engine.
Inflation And Unemployment
The Federal Reserve’s main goals are to keep inflation under control (~2% Consumer Price Index target) while keeping the unemployment rate as close to the natural rate of employment as possible (3% – 5%).
The Federal Reserve does this through monetary policy – raising and lowering interest rates, printing money, or buying bonds to inject liquidity into the system. They’ve done a commendable job since the financial crisis. However, if the Federal Reserve lowers interest rates for too long and injects too much liquidity, inflationary pressure might build up due to too much economic activity.
Inflation isn’t bad if it runs at a steady 2% annual clip. It’s when inflation starts rising to 5%, 10%, 50%, 100%+ that things get out of control because you might not be able to make enough to afford future goods or your savings lose purchasing power at too fast a pace, or you simply can’t properly plan for your financial future.
The only people who like inflation are those who own real assets that inflate along with inflation. These assets generally include stocks, real estate, and precious metals. Before the pandemic, owners of health care, child care, elder care, and higher education businesses also significantly benefitted as you can see from the chart below.
Everybody else is a price taker who gets squeezed by higher rents, higher tuition, higher food, higher transportation and so forth.
During boom times, when employers are hiring aggressively and wage growth is increasing above CPI, the Federal Reserve may need to raise interest rates before inflation gets out of control.
By the time inflation is smacking us in the face, it may be too late for the Fed to be effective since there’s generally a 3-6 month lag in monetary policy efficacy.
Higher interest rates slow down the demand to borrow money, which in turn slows down the pace of production, job growth and investing. As a result, the rate of inflation will eventually decline.
If the Federal Reserve could engineer a 2% inflation figure and a 3.5% unemployment figure forever, they’d take it. Alas, the economy is always ebbing and flowing.
Today, despite massive stimulus, to worry about inflation during a global pandemic is unnecessary because unemployment is skyrocketing. Instead, we should be more worried about deflation.
Fed Funds Rate And Our Borrowing Rates
The Federal Reserve determines the Fed Funds Rate. The market determines the 10-year Treasury yield. And most importantly, the 10-year Treasury yield is the predominant factor in determining mortgage rates.
There definitely is a correlation between the short duration Fed Funds Rate, and the longer duration 10-year yield as you can see in the chart below.
The first thing you’ll notice is that the Fed Funds rate (red) and the 10-year Treasury yield (blue) have been declining for the past 40+ years. While there have definitely been times where both rates have spiked higher between 2% – 4% within a five-year window, however, the dominant overall trend is down due to knowledge, productivity, coordination, and technology.
This long-term trend down is one of many reasons why I believe taking out an adjustable-rate mortgage mortgage with a lower interest rate will likely save you more money than taking out a 30-year fixed-rate mortgage.
What else can we learn from this chart?
1) From 1987 – 1988, the Fed raised rates from 6% to 10%. From 1994 to 1996, the Fed raised rates from 3% to 6%. From 2004 to 2007, the Fed raised rates from 1.5% to 5%. In other words, in the future, it is unlikely the Fed will raise the Fed Funds rate by more than 4%.
2) The Fed is running out of ammunition to cut rates. During the past two downturns, the Fed was willing to cut rates by up to 5% to help spur the economy along. With the current effective FFR at 1.25% – 1.5% in 1Q2020, the Fed no longer has the same amount of impact.
3) The longest interest rate up-cycle or down-cycle is about three years once the Fed starts raising or cutting rates.
4) The 10-year yield doesn’t fall or rise by as much as the Fed Funds Rate.
5) The S&P 500 has generally moved up and to the right since its beginning. The steepening ascent corresponds to the drop in both interest rates since the 1980s.
6) The average spread between the Fed Funds Rate and the 10-year bond yield has been over 2% since the 2008 – 2009 financial crisis. However, the spread has now aggressively inverted in 2020, which portends to a recession within 18 months if the Fed doesn’t aggressively cut rates.
Take a look at what happened between 2004 and 2010. The spread between the 10-year yield and the Fed Funds Rate was around 2%. The Fed then raised the FFR to 5% from 1.5% until it burst the housing bubble that it had helped to create. The FFR and the 10-year yield reached parity at 5%. Perhaps if the Fed had maintained the average 2% spread and only raised the FFR to 3%, the economy wouldn’t have collapsed as badly.
Below is a closeup chart of the S&P 500, the FFR, and the 10-year bond yield.
The Bond Market Knows Better
Now that you’ve gotten a better understanding of how the Fed Funds Rate and mortgage rates work, you should no longer automatically assume such things as:
- It’s time to refinance my mortgage now that the Fed cut rates.
- Better to refinance now before the Fed raises rates.
- Better to wait until the Fed cuts rates before refinancing my mortgage.
- Time to buy real estate now that the Fed has slashed rates.
- Time to sell real estate and other assets now that the Fed is hiking rates.
The Federal Reserve could easily raise the FFR while the 10-year bond yield might not even budge. Who is generally right? The seven Board of Governors on the Federal Reserve or the $100+ trillion bond market with thousands of domestic and international investors?
The market usually knows best. The Federal Reserve has consistently made policy errors in the past where it has raised rates when it shouldn’t have, conducted a surprise cut when it shouldn’t have, kept rates too low for too long, or kept rates too high for too long.
The Federal Reserve is trying its best to forecast the future. However, consistently forecasting the future is hard. Therefore, you might as well follow the real-time bond market to see what it’s telling us.
It is the Treasury bond market that gives us a better glimpse of the future. For example, when the yield curve inverts, history shows that there’s a high likelihood of a recession within 18 months of inversion.
The bond market had been screaming at the Fed to aggressively cut the FFR for a year before it finally did. Thankfully, the bond market also gave equity investors who had been paying attention, ample time to reduce equity exposure.
You Want The Federal Reserve On Your Side
Although the Federal Reserve doesn’t control mortgage rates, as real estate and stock investors, you absolutely want the Federal Reserve to be on your side.
The Federal Reserve can be on our side by publicly stating it is carefully observing how various events may negatively affect the economy. The Federal Reserve can also be on our side by not letting the spread between the 10-year Treasury yield and the FFR rate grow too large.
A tone-deaf Fed gives investors zero confidence. At the same time, investors want a Federal Reserve that shows strength and leadership during times of chaos. Always being reactionary instead of being proactive is an ineffective Federal Reserve.
If you want to refinance your mortgage, follow the Treasury bond market. If you follow the Fed, you’ll likely always be one step behind.
What’s Going On With Mortgage Rates Today?
Thankfully, the irrational selling of Treasury bonds is now over at the time of this post. The jump in mortgage rates actually helped lenders since they were getting crushed by demand. Now that mortgage rates are back down, I expect refinancing activity to pick up aggressively again while we shelter-in-place in April.
If you missed out on trying to refinance during the crazy volatility in March, I would try again. Although many lenders probably still have a backlog, mortgage rates should be lower as the 10-year bond yield plummets again (see chart).