What’s the Fed got to do with it?

What’s the Fed got do with it?

It is that time again. The Federal Reserve [1] cut interest rates, which creates a lot of misconceptions about mortgage rates and lending rates. The Federal Funds Rate [2] was cut by 1.25% over the weekend to a range of 0.00% to 0.25%. You might think this means a 30-year mortgage [3] dropped to zero or even by an additional 1.25%. Although it is easy to presume these rates would follow the actions of the Federal Reserve, it isn’t necessarily true. There are a variety of different types of mortgages, which include ARM’s and shorter- term fixed products. I hope to focus in on one of the most popular mortgages, the 30 year fixed and help you better understand the role of the Federal Reserve, their influence on rates, and what matters most when considering the direction of interest rates for lending products.

The Federal Funds Rate

This is the overnight lending rate banks charge other banks for excess reserves. By raising or lowering rates, the Federal Reserve is trying to slow the economy or stimulate the economy through this rate, making money cheaper or more expensive to borrow. The change in rates does not have an immediate effect on the economy, but generally takes six months or longer before we see the rate change effect the economy.

Longer Term Treasury Rates

The Federal Funds Rate can have an indirect relationship on 30-year mortgage rates. The rate should be paying attention to, however, are longer term treasury rates, such as the 10-year Treasury [4]. Treasury bonds [5] are considered one of the safest investments one can make. The 10-year Treasury and mortgage rates are intimately linked and generally move in tandem together.

Market Participants determine Rates

If you’ve been following mortgage rates, you will notice that rates have been dropping since the end of 2018, while the Federal Reserve only started lowering their rate at the beginning of August of 2019. Investors in bonds, sensing a slowdown in economic activity, already were lowering interest rates by their increased demand for safe assets, such as longer-term US Treasuries. In essence, market participants were anticipating lower interest rates later put in effect by the Federal Reserve.

Source: Freddie Mac [6], Department of Treasury [7], Federal Reserve [8] Dates November 1, 2018 through March 16, 2020, shown in log scale.

The Shape of the Curve

Interest rates do not all behave the same way. People making generic statements, such as rates are going up or down are not accurately describing rates. Rates are complex, there’s varying credit qualities, maturities and covenants. To evaluate rates across maturities, one should start with the Treasury Yield Curve [9, 10], which plots the various maturities with their corresponding rates. Typically, in a healthy economy shorter term bonds carry lower yields than longer term bonds. This is a reflection of the uncertainty and risk that exists in owning debt 7, 10 and even 30 years out. The yield curve and the shape of the yield curve is a more accurate representation about investor’s sentiment on risk and rates.

A normal yield curve slopes upward from left to right on a graph. As maturities lengthen to the right, yield should also increase.

At other times the curve might be flat, steep or even inverted. With a flat curve, there isn’t a significant difference in yield when buying a 5-year bond or 10 year bond. This would reflect a slow economy. A steep curve would reflect a strong, growing economy with higher inflation expectations and a demand for a higher interest rate. In an inverted yield curve, shorter term rates are higher than longer term rates, which reflects a growing sentiment of lower economic growth or deflation.

Why is the shape of the curve important? How could it effect current mortgage rates? How does the Federal Reserve lowering interest rates effect borrowing?

The shape of the curve tells us the general sentiment about how bond investors see economic growth. A curve that is flattening or becoming inverted signals a belief in an economic slowdown. Prior to the rate cut, mortgage rates were already falling. By the Federal Reserve lowering short term rates [2], it may cause longer term mortgage rates to fall further, but it might not. It is entirely possible that mortgage rates go higher at some point in the near future. Remember, at some point, by lowering the Fed Funds rate, it is supposed to stimulate the economy. What happens when an economy starts growing? The yield curve begins to steepen, which means longer term rates begin to rise. This happens well in advance of the Fed actually raising their rate. How soon this happens is really dependent on market sentiment and how quick of a rebound the investors are anticipating.

The Spread

Over the last month the ten-year Treasury has dropped precipitously, trading well below 1%. Typically, a 30-year mortgage trades 1.6% to 1.8% above the 10-year, which is the spread [11] or difference in rates. With the large drop in treasuries, why haven’t we seen the spread stay the same? The spread can be effected by a variety of different factors. Investors could be paying a premium for safety, making treasury rates significantly lower, making the spread (the difference) wider. On the other side of the safety premium is the risk of a mortgage versus a treasury. Since the risk is increasing in times of stress, this would also lead to the spread widening. The spread narrowing and widening is a reflection of risk existing between the two rates.

Supply/Demand

Earlier I pointed out how buyers of Treasuries can lower rates with increased demand. The same is true for mortgages. If the demand to refinance is high, lenders have to have the reserves available to lend. Lenders can’t lend out money they don’t have, keeping mortgage rates elevated as demand is processed.

Should I refinance?

Despite people using generic terms, like interest rates are going up or down, predicting the direction of interest rates is complicated and nearly impossible. Almost a year ago, some of the most astute investors in the world were predicting rates going up this year. A year later, we find the opposite to be true as rates fall.

Determining whether to refinance debt or buy a property comes down to your personal situation. You should consider how long you plan on owning the property, the impact on your cash flow [12], cost of the loan [13], payback period [14], and the impact of re-amortizing [15] a loan by extending the term. The totality of these questions in the context of your personal financial situation should be evaluated thoroughly before making this decision.

Definitions and Footnotes

• The Federal Reserve system is composed of the 12 regional Reserve Banks and the Board of Governors in Washington, D.C. As the central banking system of the United States of America, it conducts monetary policy under the dual mandate of maximizing employment and maintaining stable prices.
• The Effective Federal Funds Rate is the rate set by the FOMC (Federal Open Market Committee) for banks to borrow funds from each other. The Federal Funds Rate is extremely important because it can act as the benchmark to set other rates. Historically, the Federal Funds Rate reached as high as 22.36% in 1981 during the recession. Additionally, after the financial crisis in 2008-2009, the Federal Funds rate nearly reached zero when quantitative easing was put into effect
• Mortgage Rate: The 30 Year Mortgage Rate is the fixed interest rate that US home buyers would pay if they were to take out a loan lasting 30 years. There are many different kinds of mortgages that homeowners can decide on which will have varying interest rates and monthly payments. Sourced from Freddie Mac using the Primary Mortgage Market Survey.
• The 10 Year Treasury Rate is the yield received for investing in a US government issued treasury security that has a maturity of 10 year. The 10-year treasury yield is included on the longer end of the yield curve. Many analysts will use the 10-year yield as the “risk free” rate when valuing the markets or an individual security. Historically, the 10-Year treasury rate reached 15.84% in 1981 as the Fed raised benchmark rates in an effort to contain inflation.
• United States Treasury securities are government debt instruments issued by the United States Department of the Treasury to finance government spending as an alternative to taxation. Treasury securities are often referred to simply as Treasury.
• Freddie Mac was commissioned by the US Congress in 1970 in order to expand the secondary market for mortgages in the US. In order to achieve this end, it purchases mortgages on the secondary market and repackages them as mortgage-backed securities which it then sells to investors.Freddie Mac’s Primary Mortgage Market Survey® (PMMS®) surveys lenders each week on the rates and points for their most popular 30-year fixed-rate, 15-year fixed-rate, 5/1 hybrid amortizing adjustable-rate, and 1-year amortizing adjustable-rate mortgage products. The survey is based on first-lien prime conventional conforming mortgages with a loan-to-value of 80 percent. In addition, the adjustable-rate mortgage (ARM) products are indexed to U.S. Treasury yields and lenders are asked for both the initial coupon rate and points as well as the margin on the ARM products.
• Department of Treasury is an executive department and the treasury of the US Government. Established in 1789, it is administered by the Secretary of the Treasury. The Department of the Treasury prints and mints all US currency through the Bureau of Engraving and Printing and the US Mint. It also collects all federal taxes through the Internal Revenue Service.Daily Treasury Yield Curve Rates are commonly referred to as “Constant Maturity Treasury” rates, or CMTs. Yields are interpolated by the Treasury from the daily yield curve. This curve, which relates the yield on a security to its time to maturity is based on the closing market bid yields on actively traded Treasury securities in the over-the-counter market. These market yields are calculated from composites of indicative, bid-side market quotations (not actual transactions) obtained by the Federal Reserve Bank of New York.
• The Federal Reserve system is composed of the 12 regional Reserve Banks and the Board of Governors in Washington, D.C. As the central banking system of the United States of America, it conducts monetary policy under the dual mandate of maximizing employment and maintaining stable prices.The Effective Federal Funds Rate is the rate set by the FOMC (Federal Open Market Committee) for banks to borrow funds from each other. The Federal Funds Rate is extremely important because it can act as the benchmark to set other rates. Historically, the Federal Funds Rate reached as high as 22.36% in 1981 during the recession. Additionally, after the financial crisis in 2008-2009, the Federal Funds rate nearly reached zero when quantitative easing was put into effect. The H.15 release contains daily interest rates for selected U.S. government and Federal Reserve series.
• Treasury Yield Curve Rates: These rates are commonly referred to as “Constant Maturity Treasury” rates, or CMTs. Yields are interpolated by the Treasury from the daily yield curve. This curve, which relates the yield on a security to its time to maturity is based on the closing market bid yields on actively traded Treasury securities in the over-the-counter market. These market yields are calculated from composites of indicative, bid-side market quotations (not actual transactions) obtained by the Federal Reserve Bank of New York at or near 3:30 PM each trading day. The CMT yield values are read from the yield curve at fixed maturities, currently 1, 2, 3 and 6 months and 1, 2, 3, 5, 7, 10, 20, and 30 years. This method provides a yield for a 10 year maturity, for example, even if no outstanding security has exactly 10 years remaining to maturity.
• Treasury Yield Curve Methodology: The Treasury yield curve is estimated daily using a cubic spline model. Inputs to the model are primarily indicative bid-side yields for on-the-run Treasury securities. Treasury reserves the option to make changes to the yield curve as appropriate and in its sole discretion.
• A credit spread is the difference in yield between a U.S. Treasury bond and another debt security with the same maturity but of lesser quality. Credit spreads between U.S. Treasuries and other bond issuances are measured in basis points, with a 1% difference in yield equal to a spread of 100 basis points
• Cash flow includes personal income & expenses
• Cost of a loan can include escrow, title, credit report, appraisal and lender fees among others
• Payback period is the time it takes to recoup the cost of the loan and additional interest cost paid
• Re-amortization includes resetting the maturity of the loan, potentially extending the number of years it takes to repay the mortgage and the additional interest paid over the course of the loan.

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