I receive a number of questions regarding mortgage interest rates every time there is a meeting of the Federal Reserve Board.
Most assume that the Federal Reserve controls mortgage interest rates…and, interestingly, that’s not the case.
I’m linking to a fantastic article by Dan Green at The Mortgage Reports – he does a great job in highlighting what really takes place with mortgage rates. You can read the entire piece here…and I’ll highlight a few key pieces below.
The Federal Reserve Open Market Committee
The Federal Reserve Open Market Committee (FOMC) is a rotating, 12-person sub-committee within the Federal Reserve, headed by current Federal Reserve Chairman Jerome Powell. The FOMC meets eight times annually on a pre-determined schedule, and on an emergency basis, when needed.
The FOMC’s most well-known role worldwide is as keeper of the federal funds rate.
The Federal Funds Rate is the prescribed rate at which banks lend money to each other on an overnight basis. It is not correlated to mortgage rates.
The FOMC met a few weeks ago and dropped the federal funds rate by .25 basis points to 1.75%.
The Federal Reserve does not control mortgage rates
Here’s a fantastic graph (courtesy The Mortgage Reports) that shows how the Federal Funds Rate does not track with the 30-year mortgage rate (the green section tracks the mortgage rate, while the blue section highlights the Federal Funds rate):
When the Fed Funds Rate is low, the Fed is attempting to promote economic growth. This is because the Fed Funds Rate is correlated to Prime Rate, which is the basis of most bank lending including many business loans and consumer credit cards.
For the Federal Reserve, manipulating the Fed Funds Rate is one way to manage its dual-charter of fostering maximum employment and maintaining stable prices.
The Federal Reserve can affect today’s mortgage rates, but it does not and cannot set them.
The Federal Reserve has no direct connection to U.S. mortgage rates whatsoever.
The Fed Funds Rate and Mortgage Rates
As Dan Green states: “It’s a common belief that the Federal Reserve ‘makes’ consumer mortgage rates. It doesn’t. The Fed doesn’t make mortgage rates. Mortgage rates are made on Wall Street.
Here’s proof: Over the last two decades, the Fed Funds Rate and the average 30-year fixed rate mortgage rate have differed by as much as 5.25%, and by as little as 0.50%.
If the Fed Funds Rate were truly linked to U.S. mortgage rates, the difference between the two rates would be linear or logarithmic — not jagged.”
With that said, the Fed does exert an influence on today’s mortgage rates.
Fixed Mortgage Rates vs. Treasury Yields
A far better way to track mortgage interest rates is by looking at the yield on the 10 year Treasury bond. These two seem to track quite closely:
The 30-year fixed mortgage rate and 10-year treasury yield move together because investors who want a steady and safe return compare interest rates of all fixed-income products.
U.S. Treasury bills, bonds, and notes directly affect the interest rates on fixed-rate mortgages. How? When Treasury yields rise, so do mortgage interest rates. That’s because investors who want a steady and safe return compare interest rates of all fixed-income products…and investors move to these type of products to fulfill their needs.
What the Fed Says Impacts Mortgage Rates…and Bond Prices
Dan Green outlines how the Fed impacts rates: “the Fed does more than just set the Fed Funds Rate. It also gives economic guidance to markets.
For rate shoppers, one of the key messages for which to listen is the one the Fed spreads on inflation. Inflation is the enemy of mortgage bonds and, in general, when inflation pressures are growing, mortgage rates are rising.
The link between inflation and mortgage rates is direct, as homeowners in the early-1980s experienced.
High inflation rates at the time led to the highest mortgage rates ever. 30-year mortgage rates went for over 17 percent (as an entire generation of borrowers will remind you), and 15-year loans weren’t much better.
Inflation is an economic term describing the loss of purchasing power. When inflation is present within an economy, more of the same currency is required to purchase the same number of goods.”
Meanwhile, mortgage rates are based on the price of mortgage-backed securities (MBS) and mortgage-backed securities are U.S. dollar-denominated. This means that a devaluation in the U.S. dollar will result in the devaluation of U.S. mortgage-backed securities as well.
When inflation is present in the economy, then, the value of a mortgage bond drops, which leads to higher mortgage rates.
This is why the Fed’s comments on inflation are closely watched by Wall Street. The more inflationary pressures the Fed fingers in the economy, the more likely it is that mortgage rates will rise.