The Dilemma
As I get ready to head for bed, I can’t help but feel many of you out there are still wondering what may happen tomorrow when the Federal Reserve makes their next rate cut decision. The first thing you need to understand is that what the Fed decides does not directly impact mortgage rates.
When the Federal Reserve decides to make a rate change (or not), this only affects the Federal Funds Rate, which isn’t even consumer related. However, the Prime Rate is almost always the Fed Funds Rate plus 3%, so when they change the Fed Funds Rate, the Prime Rate changes with it.
Since Home Equity Lines of Credit are usually tied to the Prime Rate, those interest rates will likely change as well, depending on how your rate is computed which is spelled out in your loan documents.
Wait, didn’t I just say that what the Fed does doesn’t affect your mortgage? HELOCs are not your typical mortgage as they are more like a secured credit card, with the house being the collateral. They are also adjustable rate mortgages, adjusting every month in most cases. Typical mortgages, even adjustable rate mortgages, are not the same and are not tied to the Prime Rate.
Reality
Typical mortgage rates, such as those on your 30 year and 15 year mortgages are derived from mortgage backed securities (MBS or Mortgage Bonds). These are bonds traded like any other security and subject to market forces. Since inflation is the archenemy of bonds, what the Federal Reserve does with the Fed Funds Rate will impact the markets, and thus, mortgage rates as well.
Interestingly enough, mortgage rates almost always move opposite of what the Federal Reserve does with the Federal Funds Rate. That means if the Fed cuts their rate, mortgage rates will most likely rise, got it?
If you don’t get it, don’t worry. Here is a little background as to why…
When the Federal Reserve cuts the Federal Funds Rate, it allows for inflation to develop (like we have been seeing lately). Bonds don’t like inflation, so traders sell bonds, lowering the bonds’ price. When a bonds’ price drops, it’s “yield” rises and that is basically what mortgage rates are derived from, the yield of mortgage bonds. So, the Fed cuts rates and mortgage rates climb.
What Will Happen?
Now, for tomorrow’s decision, what will happen to mortgage rates. Since inflation has been climbing recently, the Federal Reserve showed decide to raise rates (long overdue in my opinion). If they are to do so, chances are mortgage rates would drop. I highly doubt our illustrious Federal Reserve would be so bold, so let’s assume they keep rates the same.
An unchanged rate will still allow inflation to grow, so if I were a trader, I would sell bonds even if the Fed leaves rates unchanged. That would mean that mortgage rates would likely climb. Heaven forbid the Federal Reserve would cut rates again (lock them up if they do), mortgage rates would likely go ballistic. Since mortgage bonds have been in a downtrend for a while now, chances are rates will continue to climb.
I hope that gave you some insight into the Fed’s decision and what happens to mortgage rates. For more on what drives mortgage rates, stay tuned to the Florida Mortgage Report and look for my book on the subject which I will be completing next month.
Ines
June 24, 2008 at 9:55 pm
Robert, you have a gift to dumb-proof information (for those that are not too Fed savvy) – did you say Book? now I know what you have been up to lately!
Clarence Swartz
June 25, 2008 at 6:18 am
Impeach Bush and Chaney ,get the country back to being sain again.
Greg Cremia
June 25, 2008 at 6:39 am
This is the second time I have been through a market like this and the one thing in common both times is, as long as the media talks about interest rates going down people will wait for a better rate to buy.
Rising interest rates get people off the fence and into our offices. Why wait for a lower price if the savings are going to be lost to a higher interest rate?
IMHO, I hope they raise the rate today. Flame suit on.
Mark Harrison
June 25, 2008 at 9:56 am
This is, I suspect, another difference between the US and UK markets.
In the UK, because something like 98% of mortgages are fixed for at most 5 years (and would go to a floating rate after that), the situation is the opposite. Bank of England base rate cuts (our equivalent of the Fed Rediscount Rate) tend to lead to immediate decreases in the rates most people pay.
… likewise, because our fixed rate prices are dominated by interest rate swap futures, rather than bond yields, the impact of lowering the base rate tends to put downward pressure on those as well.
Interest rates are an odd example in monetary policy of where the US, because it’s the global reserve currency, is actually at a disadvantage…. because oil prices are demoninated in USD, you can’t just up the base rates, let the exchange rate appreciate, and deal with external inflation that way… wheras we in the UK can (political will allowing), up the rate a point or two over 2008, let the pound slide up against the dollar, and therefore be able to buy more dollar-priced oil barrels for each pound.
Doing this would, of course, hurt exporters… but since we basically don’t have any of those any more, it’s a bit moot 🙂
Now, if the Fed CUT rates, then the impact on inflation in the rest of the G8 is, likewise, DOWNWARDS… so come on Governors, you know you want to cut 🙂 🙂 🙂
Mark in Sunny England
Matthew Rathbun
June 26, 2008 at 5:46 am
Um, is it dumb to say that maybe all of this could be just a bit simpler? Here’s where I am coming from…. Greg hit it on the head. So long as the media plans on screwing people with this constant “market condition sucks” crap, we’re all going to suffer.
The main stream media doesn’t report on the Fed system and how it really effects people for a variety of reasons a) it’s not sexy b.) there’s no gossip or drama c.) most of them don’t understand it and d.) consumers don’t care how it all works.
As for the federal reserve or the president for that matter, they could do anything and everything right and until the news sources stop trying to cause this economy we’re not going to find out way out of it.
Here’s my hope: A new president get’s elected (nothing will really change other than perception) and when they take office the Media will decide if they really want to support or screw the new guy. Once they’ve made that decision than they’ll tell all us simply minded folks what to think and we’ll either get better or all drink some kool-aid.
Yeah, I’m pretty tired of the economy, the media and the lemming type mentality of the consumer…
Jim Lee
June 27, 2008 at 9:05 am
My bet is that the Fed does nothing today.
Robert D. Ashby
June 27, 2008 at 12:20 pm
@Ines…Thanks for the compliment and yes, I am working on a book and part of the reason I have all but disappeared at times.
@Greg…The media does have the power to move the mob and that can make them do crazy things, like wait for a lower rate while rates are going up. It is always fun trying to explain why rates are higher today while the client insists that rates are dropping becuase of what they heard.
@Mark…Yes, this is another case where we differ from the markets abroad, such as the UK. The fact you cannot get a “fixed rate” longer than 5 years is another reason mortgage acceleration programs are worthwhile in other countries, but are not in the US.
@Matt…The media loves to invoke fear (hey, fear sells almost as well as sex). We can count on them fueling the fire on both sides (recession and inflation) forever, whichever is better that day at putting money in their pockets.
@Jim…They didn’t do anything as expected the other day and now look at the price of oil. Just remember, there is no inflation.
Shane Sheibani
July 9, 2008 at 6:14 am
Interesting post and I concur with the beneficial effects of an interest rate hike. Our weakened dollar can bear a lot of blame for the runaway gasoline prices. Raising the rates can both motivate R.E. buyers who are hesitating AND improve the sales picture in outlier areas that depend on commuters (gasoline consumers) seeking cheaper RE alternatives to older neighborhoods. High gas prices keeps many folks renting in the urban core instead of making the jump to buy in to distant suburbs