I received an enormous number of questions this last month about interest rates, many focused on why the Fed elected not to lower interest rates in July and more questions about emergency cuts. When is good news actually bad news and when is good news really good news? What about the meeting this month?
When I get these questions I often ask, what rate are you talking about? It is almost 10 out of 10 times that the real estate investor asking me about rates is asking about mortgage rates. Many people get confused about the differences between the Fed rate and mortgage rates. I want to start by being very clear that mortgage rates are not set in the Fed meetings. They are not set by the government at all. Mortgage rates are set by the market which is not a perfect correlation to the rate the Fed does control. In fact, there are many times when the fed rates drop, and mortgage rates go up.
The Fed rate is the overnight rate that banks pay to borrow. They borrow money at this rate and loan it out to you and me at a higher rate. That is how banks profit. They are allowed to borrow this money as a multiple of their deposits so the more deposits they have, the more they can leverage up. The Fed sets this rate as a tool to help slow or stimulate the economy. When rates are low, banks borrow more and lend for larger profits. This puts liquidity into the market. When rates are high, banks slow lending because consumers do not want to pay the rates banks charge to make money. This tends to slow the economy.
Mortgage rates are far more complicated. Mortgage rates are often described as being tied to the 10-year treasury. That is because there is almost a perfect correlation to the 10-year treasury with a small exception of the spread. The spread is the amount above the 10-year yield an investor expects to earn. Let me explain.
Bond Market
Mortgage rates are set by the mortgage bond market. A mortgage bond is large group of mortgages packages together and sold to passive investors. Lenders package and sell mortgages to free up capital so they can make more loans. Fannie Mae is the largest buyer of these mortgages, but other institutional investors buy mortgage bonds as well.
Rates charged to borrowers, like you and me, are based on what rate of return these bond investors are demanding. Mortgage rates have a strong correlation to the 10-year because the 10-year is the gold standard for a long-term rate as it is considered to be the long term “risk-free rate.” The spread is the rate above the 10-year that investors need to earn to compensate them for risk. So, think about an investor wanting to buy a mortgage. What rate would they need to earn over the 10-year to get them to choose the mortgage as their best investment option? The long-term average is around 1.7% but we have seen that increase in recent years. Risk can mean more than just a risk of defaults or a risk of property values declining. There is also interest rate risk which is prevalent in this market and could be playing a role in the higher spread. If rates were to go down as we expect, borrowers will likely refinance their loans meaning the mortgage bond investor will lose out on the current interest. For that reason, it is possible that they are demanding a higher rate now to capture as much income as possible before a flurry of refinances begins.
Supply
Although it is an accurate statement that the bond market sets mortgage rates, it all comes down to supply and demand. The more treasuries or securities there are to sell, the higher the interest rate must be to attract enough buyers. When the government needs to raise capital and decides to do that by offering a bunch of treasuries, we would expect to see a pop in rates. What the government does with that money, however, could drive rates back down. It is complicated, but it is important to note that we can see the treasury department release short term treasuries and/or long term. When raising capital, if they choose to issue more short-term debt than long term debt, the rates on long term debt would go down. This would bring mortgage rates down.
Demand
The other side of course is if there is demand for treasuries. We are lucky in this country because the dollar is considered by most to be the world reserve currency. It is the currency that most countries have confidence in and are willing to invest in. This is why counties such as China invest heavily in US Treasuries. High demand like this will drive rates down. This will sound crazy, but the government also owns its own debt and can increase demand by buying treasuries. More than that though, although it does not directly set mortgage rates, the government can have a direct impact on mortgage rates by purchasing mortgage bonds. If Fannie Mae gets a green light to purchase more loans, this is normally done by easing credit standards, mortgage rates should drop.
What impacts demand for long term debt is beyond the scope of what I can explain in a short article like this, but the list of possible contributors is massive. Think about other countries desire to purchase US debt, inflation, current and expect default rates, interest rates, stock values and trends, employment rates, government decision (which is not limited to the Federal Reserve), corporate profits, environmental concerns, and possibly an election.
So, What About Mortgage Rates?
So, the big question of course is if we see a rate cut this month, what does that mean for mortgage rates? The answer is I really don’t know, but I suspect nothing. If rates do come down in a meaningful way, it will be more likely because of some negative news in the economy. I believe an uptick in unemployment would do it. The reason for that is because investors will pull money from stocks out of fear and invest in debt which is much safer and consistent (an increase in demand). I do also agree with most economist that rates will come down over time and we likely have seen the peak in this cycle, but how much and when they come down is the question.