The Fed Lowers Rates, But Mortgage Rates Go Up. What's Happening?

Whenever the Fed lowers interest rates, there is always a lot of anticipation, publicity and reaction in the markets.

Most consumers think that the drop by the Fed means that mortgage rates will be lower. There is not a direct cause and effect relationship between these two.

Here are some of the reasons:

The Federal Reserve exerts some control over the interest rate paid by U. S. banks for overnight loans from the Federal Reserve or between banks. These are the Fed Funds rate and the discount rates that get all the press coverage and commentary in the financial news.

The cheaper supply of these funds help banks with liquidity, but it would be very risky for a bank to make a long-term, 30-year mortgage loan that is tied directly to this overnight rate. These rate changes most often will affect the prime rate, and short-term consumer loans and credit cards.

If a bank takes out a short-term loan of $300,000 from the Fed and lends it to a homebuyer for 30 years, the bank still would need to come up with $300,000 to pay the Fed back right away. They could repay by borrowing another $300,000 on a short-term loan, but then it has to continually roll this over. If short-term rates go up, the bank loses money because it has a contract with the borrower for 30 years.

Mortgage lenders that make long-term loans negotiate with the capital markets that include banks, corporations, institutions, pension funds, governments and other investors who buy and sell money. Many times lenders will bundle many mortgages into a package called a Mortgage Backed Security and sell it through Wall Street.

These investors are lending for the long term, so they agree to be paid back in installments which includes an interest rate that is fixed for the life of the loan. As long as the money that the mortgage lender is paying to the investor is lower than the rate it is charging its borrower, the lender will make money.

Long-term lending is based largely on rates paid by the U.S. Treasury when it auctions off new issues. Treasuries are considered very safe - mortgage products would be considered riskier - so the rates on home loans will be higher than the Treasury rates.

In the past, the change in mortgage rates were pegged to changes in the 30-year bond. In recent years, the 10-year bond has been more indicative of investor expectations because a majority of loans get repaid in the first 10 years.

The investors must gauge the risk that they are taking by investing in mortgage products vs. buying the safe Treasury issues. In the past, there was a fairly predictable risk premium over the Treasury values that the investors felt comfortable with.

Recently, because of dropping property values, and the poorer performance on mortgage loans by borrowers, investors have widened the risk premium that they are expecting over the safe Treasury bond yields.

The bond yields are largely influenced by fear (or lack of fear) of inflation. When inflation is forecast, Treasury yields will move higher because investors do not want to buy a Treasury bond today that will will be worth substantially less in the future because inflation has eroded the value of the dollar. When inflation is less of a concern, we see that the Treasury yields go lower and mortgage rates follow that pattern.

So, when the Fed eases interest rates, it has the tendency to make the money supply increase, which will fuel inflation concerns. This money will leave the bond market with its fixed rate of return and go into the stock market where growth, stimulated by the new money supply, is anticipated.

As a result, the Federal Treasury still needs money to operate and will offer new Treasury bonds at higher and higher rates until it attracts the money that it needs.

This dynamic creates the situation that seems so puzzling: the Fed reduces interest rates and mortgage rates go up.

As John Schoen of MSNBC summarized - "...the Fed could cut short-term rates to zero, and it wouldn't cut the cost of long-term mortgage rates".

If you want to monitor the direction that mortgage rates are anticipated to go, you can check the 10-year bond yield periodically. I use http://money.cnn.com/markets/bondcenter/.
It is important that you focus on the direction that the yield is going. Do not focus on the direction that the price is headed, because bond prices and bond yields work in opposite directions.

I'm sure that most of you don't want to become market technicians, but think how people will respond to you at your next cocktail party when you share this information!