Why Fed Rate Cuts do not lower mortgage rates by Evan Swanson, CMPS

The Fed is at it once again slashing short-term interest rates with the hopes of helping the economy avoid a steep recession. Many people, including so-called “experts” in the media, believe the recent Fed cuts are the reason why mortgage rates touched 4-year lows on January 22nd. However, if you look at history the results may surprise you.

Let’s first remember that the Federal Reserve can only control the Discount Rate and Fed Funds Rate. These are short-term rates used for overnight lending between banks and can change from day to day. This is very different than 30 year mortgage rates which remain fixed for a much longer period.

The last time the Fed went on a lengthy rate cutting cycle was back in 2001. In the span of 12 months (January- December) the Fed cut the Fed Funds Rate from 6.00% to 1.75%. To an uninformed consumer one would think that mortgage rates would have also decreased significantly over that timeframe. In fact, 30 year fixed rate mortgages actually increased from 6.95% in March to 7.07% in December (source: www.freddiemac.com).

In the most recent cycle, the Fed began cutting short-term interest rates on September 18th, 2007. From then until now the Fed has slashed short term interest rates from 8.25% down to 6.00%. Over that timeframe mortgage rates have come full circle starting at around 6.25%, falling as low as 5.00% in late January, and now back up to the 6.25% range in late February.

The truth is that fixed mortgage rates are wholly determined by the direction that mortgage-backed bonds trade. Mortgage-backed bonds are bonds which are sold to investors that are backed by the mortgages that you and I pay interest on. When the demand for these assets increase it drives up the price and lowers the yield. This is what causes mortgage rates to decrease and vice versa.

So, what is it that causes the prices of these assets to fluctuate? Like other asset classes such as stocks, there are many factors that we can identify. However, the primary factor is inflation expectations. If you think about it this makes sense. If you’re going to lend another person some money today and you expect the purchasing power of that money to be significantly less in the future, due to inflation, then you will charge them a higher rate of interest in order to borrow your money.

This is exactly the case for mortgage rates. When inflation expectations increase so do mortgage rates and vice versa. So when do inflation expectations rise or fall? Again, there are a myriad of factors that can influence inflation expectations including commodity prices, the economic outlook, and inflation data.

However, I would argue that mortgage rates recently touched 4-year lows not because of the Fed’s rate cut but because of the fear and concern that the Fed raised when they made their surprise .75% on the morning of January 22nd.

For now investors are beginning to realize that the implication of the “easy-money” monetary policy combined with the generous fiscal stimulus package is likely to be increased inflation.