I’m asked regularly about mortgage rates – and how they behave relative to the Federal Reserve and their Federal Funds rate.
While it might seem intuitive that changes in the federal funds rate should directly affect mortgage rates, the relationship between the two is more complex.
Mortgage rates do not move in lockstep with the federal funds rate due to multiple factors, including the role of longer-term bonds, overall market dynamics, and investor sentiment.
Let’s take a closer look…
The Role of the Federal Funds Rate
The federal funds rate is the interest rate at which banks lend reserves to each other overnight. It is set by the Federal Reserve as a tool to control monetary policy, with the goal of managing inflation and stimulating economic growth.
When the Federal Reserve raises or lowers this rate, it directly affects the short-term borrowing costs for banks, which can influence consumer rates for products like credit cards and auto loans.
However, it is much more indirect when it comes to mortgage rates, which are typically tied to other longer-term financial instruments. The federal funds rate is a short-term rate, while mortgages often span 15 to 30 years, leading to differing influences on these financial products.
Influence of Longer-Term Bonds on Mortgage Rates Mortgage rates are more directly influenced by the yields on long-term bonds, particularly the 10-year U.S. Treasury bond.
Investors use the yield on these bonds as a benchmark for determining mortgage rates, as they represent a relatively safe long-term investment. When the yield on 10-year Treasury bonds rises, mortgage rates often follow suit, and when it falls, mortgage rates tend to decrease.
This connection is much stronger than the relationship between mortgage rates and the federal funds rate because both mortgages and Treasury bonds are long-term financial commitments that reflect broader economic expectations over time.
Market Forces and Supply-Demand Dynamics
The supply and demand for mortgage-backed securities (MBS) also play a significant role in determining mortgage rates.
Banks and mortgage lenders often bundle mortgages into securities and sell them to investors, and the demand for these securities can influence the rates that lenders offer to consumers. When demand for MBS is high, lenders can offer lower mortgage rates, as they can sell the bundled mortgages more easily at favorable terms.
On the other hand, when demand for these securities fades, lenders must increase mortgage rates to make them more attractive to investors. This dynamic operates independently of changes in the federal funds rate, as it is more tied to market sentiment and investor appetite for longer-term fixed-income investments.
Impact of Inflation Expectations
Inflation expectations are another key factor that drives mortgage rates, often with minimal direct influence from the federal funds rate.
Mortgage lenders are keenly aware of inflation risks over the life of a loan, which can erode the real value of the fixed interest payments they receive. If inflation is expected to rise, lenders will demand higher mortgage rates to compensate for the anticipated decrease in purchasing power.
Alternatively, when inflation expectations are low, mortgage rates usually drop – or stay hover at a lower rate. The federal funds rate does influence inflation to some extent, but the relationship is not always immediate or proportional, resulting in instances where mortgage rates may not track movements in the federal funds rate.
Global Economic Factors and Risk Aversion
Mortgage rates are also influenced by global economic conditions and risk aversion among investors.
For example, during periods of global economic uncertainty, investors often flock to safe-haven assets like U.S. Treasury bonds, driving their yields down and potentially lowering mortgage rates in turn. This dynamic was particularly evident during the 2008 financial crisis and the COVID-19 pandemic, where mortgage rates fell despite significant volatility in the federal funds rate.
This illustrates that external economic factors and the global appetite for safe investments can decouple mortgage rates from domestic monetary policy changes, creating a gap between mortgage rates and the federal funds rate.
The Role of Mortgage Lender Pricing Strategies
Individual mortgage lenders also play a role in determining rates through their own pricing strategies, which can introduce further variations. Lenders adjust their rates based on competition, risk assessments, and internal profit targets.
These adjustments mean that even if the broader market conditions suggest a decrease or increase in rates, lenders may not always follow suit immediately.
For example, during times of economic stress or uncertainty, lenders may keep rates higher to offset increased risks of defaults. This autonomy in pricing further weakens the direct relationship between the federal funds rate and mortgage rates.
The Delayed Response of Mortgage Rates to Rate Changes
Even when changes in the federal funds rate indirectly influence mortgage rates, the response is often delayed.
When the Federal Reserve adjusts the federal funds rate, it can take months for the effects to filter through the economy and reach the mortgage market. This lag occurs because it takes time for banks to adjust their lending practices, for market expectations to shift, and for the impacts on inflation and economic growth to become clearer.
During this time, other factors, such as changes in the housing market, shifts in investor sentiment, or unexpected economic data, can alter the trajectory of mortgage rates independently of the federal funds rate.
In Conclusion
While the federal funds rate plays an important part in shaping broader economic conditions, it does not directly dictate mortgage rates due to the factors mentioned previously.
Mortgage rates respond more directly to the yields on longer-term bonds like the 10-year Treasury and are subject to a range of market forces that the federal funds rate cannot control.
If you’d like to find out more, or have a detailed conversation about mortgage rates and where they might be headed, don’t hesitate to reach out to me, as it would be my pleasure to help in any way I can!
The blog postings on this site represent the positions, strategies or opinions of the author and do not necessarily represent the positions, strategies or opinions of Guild Mortgage Company or its affiliates. Each loan is subject to underwriter final approval. All information, loan programs, interest rates, terms and conditions are subject to change without notice. Always consult an accountant or tax advisor for full eligibility requirements on tax deductions.
