The Federal Funds Rate & Fixed Mortgage Rates
The Federal Funds Rate sets the interest rate banks charge each other on overnight loans made to meet reserve requirements. The Federal Funds Rate also determines the Prime Rate, upon which many business and consumer loans are based. When the Federal Funds Rate is low, the Fed is attempting to promote economic growth. When it is high, the Fed is attempting to dampen inflation. Manipulating the Federal Funds Rate is one way the Federal Reserve manages its dual charter of fostering maximum employment and maintaining stable prices.
U.S. mortgage rates are not set by the Federal Reserve. There is no direct connection. Want proof? In November, 2008 the average thirty year mortgage rate was 5.70% higher than the Federal Funds Rate. In July, 1973 it was 2.35% lower. If the Federal Funds Rate were truly linked to U.S. mortgage rates, the spread between the two rates would be a lot more consistent.
So what does determine long term mortgage rates?
Mortgage-Backed Securities, U.S. Treasury Rates & Fixed Mortgage Rates
Few lenders keep the mortgage loans they make. Most loans are sold on the secondary mortgage market in large portfolios called mortgage-backed securities (MBS). 15 and 30 year mortgage rates are determined by the yield investors demand on mortgage-backed securities. MBS’s compete with other fixed rate investments for investment dollars, primarily U.S. Treasury notes and bonds. Treasuries are guaranteed by the U.S. government, so they are less risky and their yields are generally lower than mortgage-backed securities. Consequently fixed mortgage rates, based on MBS rates, usually average about 1.70% higher than 10 year Treasury notes. The correlation between U.S. Treasury rates and mortgage rates is pretty clear:
So what determines U.S. Treasury yields?
Market expectations about inflation heavily influence Treasury yields. So if the Federal Reserve indicates that inflation is expected to rise because of positive job reports, GDP numbers, or anything else, Treasury yields, and mortgage-backed security yields that compete with Treasuries, tend to rise. Conversely, when the Fed outlook is generally negative, rates tend to fall. The correlation between inflationary expectations and mortgage rates is clear. When inflationary expectations are high, rates are high. When inflationary expectations are low, rates are low. So listen to what the Fed says about inflation.
What else has a big effect on rates?
U.S. Treasuries are a safe investment in an uncertain world because the U.S. government guarantees them. When investors seek the safety of Treasuries, the price goes up and the yield goes down. For instance, investors fled from European investments after Great Britain voted to leave the European Union last summer, and the 10-year Treasury note yield fell to 1.46% on July 1, 2016. And when investors sell Treasuries to invest in stocks, real estate, or non-U.S. investments, the yield rates go up. After the 2016 U.S. elections many investors sold Treasuries to buy stocks because they thought potential tax cuts, deregulation, and economic stimulus packages made stock more attractive. The 10 year Treasury yield quickly rose from 1.80% to 2.30%, and thirty year mortgage rates rose 0.50%.
What does this mean for your mortgage?
If you are about to refinance or purchase a new home, don’t fuss over Federal Reserve activities. Instead, watch the French elections next month. Should La Pen’s nationalist agenda win and France also decides to leave the E.U., billions may again flow into Treasuries, and mortgage rates would drop.
Or maybe not.
What do you think?