Rates & A Fed Rate Cut (7/27/2019)

I am very impressed that so many people I spoke to this week have asked about mortgage rates next week, when the Federal Reserve is expected to cut rates. This was the perfect catalyst for this week’s article.

Raise your hand if you believe that if the Fed cuts rates next week it will lower mortgage interest rates…

If you automatically raised your hand, you were part of the majority. But the correct answer is maybe.

It is anticipated that at next week’s Federal Reserve meeting that Chairman J Powell will announce either a one-quarter or one-half percent rate cut (¼% to ½%) to the Federal Discount Rate. The federal discount rate is the interest rate charged by the central banks to the member banks as a measure to reduce liquidity problems and the pressures of reserve requirements. This is not a cut to mortgage interest rates.

How does a cut to some member-bank interest rate affect you and your mortgage?

The purpose of the Fed changing interest rates charged to the banking world is the Fed’s way of regulating the growth of the economy. When rates are low, cheap money allows for more economic activity. When rates are high, it stifles economic growth. The Fed is concerned that the expansion of the economy we are enjoying in the US may slow down early next year. To combat a possible 2020 Recession, the Fed is proactively cutting rates to give a little kick to the economy.

The Fed is playing with fire when they monkey too much or too quickly with interest rates. If they cut rates too much and spur vast economic activity, it could spark higher inflation – which isn’t good for anyone. If rates are too high, the economy falters, and recession is a possibility.

How the Fed rate cut with affect mortgage rates is very simple:

The investors on Wall Street will determine if the Fed’s action and statement of forward thinking on future monetary policy is inflationary or not. It is how the stock and bond markets react, that will set the tone of where interest rates will go next week.

If it is perceived by investors that the Fed rate cut will cause inflation, the bond market will not like it. Bond yields (rates) will rise, and so will mortgage interest rates. Inflation is the kryptonite of bonds. If you own a bond, and there’s 3% inflation, every year your bond will lose 3% of its value. In order to make up for that loss of value, the interest rate given by that bond must be higher than the what inflation will take from it.

If the perception is that the Fed needs to do more, and the cut they are projected to make will do very little to inflation, the bond market may rally, and help send mortgage rates lower than where they are today.

Monetary policy, the relationship between the bond market and stock market, inflation and recession forecasts, are subjects that people are paid the big bucks to understand and forecast. I hope my short presentation of how these factors influence mortgage rates leaves you will a somewhat clearer understanding. Given what we all now know, let’s use this knowledge to see what happens next week when the Fed meets. At this point speculating one way or another is no different that heading to Las Vegas and betting on Black or Red.