Fed Rates Down, Mortgage Rates Up — How Come?
Published by bmccord March 28th, 2008 in Economics. Tags: No Tags.I’ve lost count of the number of times I’ve been asked “I see the Fed lowered it’s rate(s) today, www.federalreserve.gov/ how much have mortgage rates dropped by”. When I answer, as is most often the case, “they’ve not gone down, they’ve gone up”, the response is “how can that be.
So let’s try to explain it once and for all.
First the basics.
There are 3 actors in this story.
1.The Federal Reserve Bank.
2. Mortgage Backed Bonds/Securities.
3. Inflation.
FACT: There is no direct relationship between the Federal Reserve and Mortgage Interest Rates.
FACT: Despite the continued repetition from the Talking Heads in the mainstream media, there is also no direct connection between the 10 year Note and Mortgage Interest Rates. In fact the two will often go in opposite directions after a Fed action.
SUPER FACT: Mortgage Interest Rates are directly affected ONLY by the prices of Mortgage Backed Bonds, commonly referred to as Mortgage Backed Securities. For the most part these are Long Term Bonds issued by FANNIE MAE and FREDDYMAC, and it their price going up or down which drives Mortgage Interest Rates.
As with all Long Term investments, Bonds are most directly affected by the outlook for Inflation, which makes it likely they will be be paid back in the future with inflated dollars. Inflation reduces the current value of all Fixed Investments such as Bonds.
The Golden Rules:
1. Prospects of higher Inflation drive down prices of all Bonds.
2. When Bond prices go down, Mortgage Interest Rates go up, and vice versa.
Here is where the Fed comes in. Drastic lowering of rates by the Federal Reserve Bank will always lead to fears of Inflation and put downward pressure on all Bonds. This is precisely what we have seen since the start of this lowering cycle on Sept 18th last year.
The sole excemption to this is your Home Equity Line of Credit which is often tied to the Prime Rate. The Prime rate is historically 3% more than the Fed Funds rate; so in todays topsy turvey world you could actually find your Equity Line loan having a lower interest rate than your 1st. Mortgage.
You did a very nice job of explaining a complex situation. Thanks.
Nice job on an explanation of interest versus mortgage rates. Finance is perhaps one of the most difficult concepts for Mr./Ms./Mrs. Public to grasp!
A clear explanation of interest vs. mortgage rates. Finance is perhaps one of the most difficult concepts for Mr./Ms./Mrs. Public to grasp!
I totally agree with your article! Thank you for the clear explanation. I have written a related article on my own blogsite.
Hi Bill,
This really is a strange and poorly understood thing. Most folks assume that the Fed rate and mortgage rates are very closely linked. Great explanation, thanks.
I could point some of my clients to your blog now, you have explained it so well. The day the fed drops the rate my call and email volume goes to roof asking same question “fed drop the rate by 1/2 point so the mortgage rates should be down by 1/2 point”