With so much news about the Federal Reserve recently, I’ve received a ton of calls from people saying they want to move fast because the Fed is going to raise rates. If there’s one thing you take from this article, let it be that the mechanism of the Federal Reserve raising rates will directly impact mortgage rates is false.
Let’s start with the Federal Reserve and what they control. The Fed has only 2 tools in their arsenal.
First, the Fed controls two important monetary rates. The Fed Funds Rate and the Discount Rate. These are in the simplest way to describe them short-term loan programs member banks can access. Member banks don’t borrow money from the Federal Reserve to then lend for mortgages, so when the Fed raises or lowers these rates, it doesn’t directly impact mortgage rates.
The purpose and hopeful results of the Fed manipulating these two specific interest rates is to either speed up or slow down the economy. Make rates low, businesses can borrow cheap, and they’ll use that opportunity to expand. Make it expensive to borrow short-term, which is how businesses do it, and they’ll take a break, thus slowing economic growth.
Just to demonstrate how disconnected the Fed raising rates is from your perception of what happens, when the Fed actually does start to raise rates next month, mortgage rates should benefit and drop. That’s the exact opposite of what most people would think. The reason for the opposite reaction has to do with inflation. I’ll get to that shortly.
The other tool the Fed has, is the one that really affects mortgage rates, but consumers rarely hear about it. The Federal Reserve in times of economic upheaval will buy US Treasury debt (notes and bonds) and Mortgage Backed Securities (MBS). Like any other commodity that follows the rule of supply and demand, when you have more buyers wanting your product, you can get away with selling at a higher price. For bonds, we don’t think in terms of “price” but instead “interest rate”. The same rules apply. If you have greater demand for your bonds, you don’t have to offer a very high interest rate for people wanting to buy them.
Since the start of the pandemic, the Federal Reserve has kept mortgage rates artificially low by buying massive amounts of Mortgage Backed Securities. MBS is created when your mortgage is funded by your lender, and that loan is sold to Fannie Mae and Freddie Mac. Your loan is collateralized into MBS and sold to investors – the Fed being the biggest purchaser during the pandemic. Over the past two years the Fed’s portfolio of MBS has grown to over 12 trillion dollars.
What’s triggered the rapid jump in mortgage rates, nearly a full 1% rise in less than 2 months, is the Fed announcing that they will not only stop buying new MBS, but they will actively reduce what they already have. Let’s revisit the supply and demand rules. Now the situation is significantly diminished demand, with lots of product available. The rules dictate you must slash prices to move the inventory. But with bonds, we don’t use price, we use rate. In order to move bonds, you have to offer investors higher rates to entice sales. This reduction of the Fed’s balance sheet and no longer buying MBS is the primary reason for the jump in mortgage rates.
Let’s also discuss inflation and its effect on mortgage rates. As we all know from watching the news recently, inflation is bad because is eats away the underlying value of our assets. For example: If one has $10,000 in savings and the inflation rate is 5%, in one year that $10,000 is now worth just $9,500. The same is true of the 3 trillion dollars in MBS that needs to be purchased by investors annually. If inflation is eating away at the underlying value of MBS, the investors will need to get a higher interest rate on those bonds to offset the inflation. You may ask: If inflation is now running between 5%-7% why would someone buy bonds earning them around 2%? We’ll save that for another article.
To answer the question earlier in the article of why mortgage rates would benefit from the Fed hiking rates, the answer is easy to understand. With the Fed taking action to curb inflation, it helps pacify the fears bond buyers have going forward. The question remains how will the action the Fed is taking affect inflation? That’s where bond buyers must speculate.
It is important to note that there are other external forces that influence interest rates. Wars, stock market runs or corrections, and other events that affect world markets. While no one can forecast where mortgage rates will be tomorrow, we do know the fundamental forces that affect rates. Those forces will continue to pressure rates higher. The Fed is just at the beginning of their bond tapering program. Inflation is not forecast to drop for a while. While we all like to look back at what mortgage rates were just a few weeks ago, those rates are no longer applicable. Your decision now is to either take the rates available today or accept what’s available in the future.