Ever wonder why mortgage interest rates sometimes don’t increase when the Federal Reserve hikes interest rates and vice versa? The simple answer is: the Fed does not control mortgage interest rates.
Instead, the Federal Reserve controls the Fed Funds rate, which is an overnight interbank lending rate. An overnight rate is the shortest lending term. Shorter duration lending rates affect credit card interest rates and short-term car loan interest rates. Not so much longer-term mortgage rates.
Therefore, longer duration U.S. Treasury bond yields have a far greater influence on mortgage interest rates.
Federal Reserve Controls The Fed Funds Rate
The Federal Reserve controls the Federal Funds rate. The Fed Funds rate is the interest rate everybody is referring to when discussing cutting or increasing interest rates. The Federal Funds rate is the interest rate in which banks lend to each other, not to you or me.
There’s generally a minimum reserve requirement ratio a bank must keep with the Federal Reserve or in the vaults of their bank, e.g. 10% of all deposits must be held in reserves. Banks need a minimum amount in reserves to operate. It is similar to how we need a minimum amount in our checking accounts to pay our bills. At the same time, banks are looking to profit by lending out as much money as possible at a spread.
If a bank has a surplus over their minimum reserve requirement ratio, they can lend money at the effective Federal Funds rate to other banks with a deficit and vice versa. A lower effective Fed Funds rate induce a lot more inter-bank borrowing in order to re-lend to consumers and businesses and help keep the economy liquid.
This is exactly what the Federal Reserve hoped for once they started lowering interest rates in September 2007 as home prices began to decline.
Study the charts below.
By the summer of 2008, everybody was freaking out because Bear Sterns was sold for a pittance to JP Morgan Chase. And then on September 15, 2008, Lehman Brothers filed for bankruptcy. Nobody expected the government to let Lehman Brothers go under. When they did, that’s when the panic really began.
What happens when everybody freaks out? Banks stop lending and people stop borrowing! This is what we economists call “a crisis of confidence.” The Federal Reserve lowered the Federal Funds rate in order to compel banks to keep funds flowing. Think of the Federal Reserve as keeping the oil flowing through a dying car engine.
With fears of a recession again in 2020 largely due to the coronavirus, the Federal Reserve conducted an inter-meeting rate cut of 50 basis points in March. With the 10-year bond yield well below 1% and the Fed Funds rate range at 1.25% – 1.5%, it is clear the Federal Reserve will have to cut again.
Inflation And Unemployment
The Federal Reserve’s main goals are to keep inflation under control (2% CPI target) while keeping the unemployment rate as close to the natural rate of employment as possible (3% – 5%).
The Federal Reserve does this through monetary policy – raising and lowering interest rates, printing money, or buying bonds to inject liquidity into the system. They’ve done a commendable job since the financial crisis. However, if the Federal Reserve lowers interest rates for too long, inflationary pressure might build up due to too much economic activity.
Why is inflation bad? Inflation isn’t bad if it runs at a steady 2% annual clip. It’s when inflation starts rising to 5%, 10%, 50%, 100%+ where things get out of control. In such a scenario, you might not make enough to afford future goods or your savings are losing purchasing power at too fast a pace. Or you simply can’t properly plan for your financial future.
The only people who like inflation are those who own real assets that inflate along with inflation. These assets generally include stocks, real estate, and owners of health care, child care, elderly care, and higher education businesses! Everybody else is a price taker who gets squeezed by higher rents, higher tuition, higher food, higher transportation and so forth.
Inflation Is Great For Investors
During boom times, when employers are hiring aggressively and wage growth is increasing above CPI, the Federal Reserve may need to raise interest rates before inflation gets out of control.
By the time inflation is smacking us in the face, it may be too late for the Fed to be effective since there’s generally a 3-6 month lag in monetary policy efficacy.
Higher interest rates slow down the demand to borrow money, which in turn slows down the pace of production, job growth and investing. The rate of inflation will eventually decline as a result.
If the Federal Reserve could engineer a 2% inflation figure and a 3.5% unemployment figure forever, they’d take it. Alas, the economy is always ebbing and flowing.
Today, we have negative real mortgage rates, which is huge for the real estate industry. More people will borrow more money. And given the real interest rate is negative, it’s like getting paid to borrow money!
As a result, the housing market should stay strong for years to come. I would not be wanting to rent post-pandemic. Rents and real estate prices are going to continue going up.
Fed Funds Rate And Our Borrowing Rates
The Federal Reserve determines the Fed Funds rate. The Federal Reserve does not determine mortgage rates. Instead, the bond market determines the 10-year Treasury yield. And the 10-year Treasury yield is the predominant factor in determining mortgage rates.
There is definitely a correlation between the short duration Fed Funds rate, and the longer duration 10-year yield as you can see in the chart below.
The first thing you’ll notice is that the Fed Funds rate (red) and the 10-year Treasury yield (blue) have been declining for the past 40 years. There have definitely been times where both rates have spiked higher between 2% – 4% within a five-year window. However, the strong trend is down due to knowledge, productivity, coordination, and technology.
This long-term trend down is one of the main reasons why taking out a 30-year fixed rate mortgage over an adjustable rate mortgage will likely cost you more money than necessary.
What else can we learn from this chart?
1) From 1987 – 1988, the Fed raised rates from 6% to 10%. From 1994 to 1996, the Fed raised rates from 3% to 6%. From 2004 to 2007, the Fed raised rates from 1.5% to 5%. In other words, it is unlikely the Fed would ever raise the Fed Funds rate by more than 4% in the future.
2) The Fed is running out of ammunition to cut rates. In the past two downturns, the Fed would be willing to cut rates by up to 5% to help spur the economy along. With the effective Fed Funds rate at 1.25% – 1.5% in 1Q2020, the Fed might not be able to make as large of an impact any more.
3) The longest interest rate up-cycle or down-cycle is about three years once the Fed starts raising or cutting rates.
4) The 10-year yield doesn’t fall or rise by as much as the Fed Funds rate. I explain why in this article.
5) The S&P 500 has generally moved up and to the right since its beginning. The steepening ascent corresponds to the drop in both interest rates since the 1980s.
5) The average spread between the Fed Funds rate and the 10-year bond yield has been over 2% since the 2008 – 2009 financial crisis. However, the spread has now aggressively inverted in 2020. This portended to a recession.
Spread Between The 10-Year Yield And Fed Funds Rate
Take a look at what happened between 2004 and 2010. The spread between the 10-year yield and Fed Funds rate was around 2%. The Fed then raised the Fed Funds rate to 5% from 1.5% until they burst the housing bubble it helped create.
The Fed Funds rate and the 10-year yield reached parity at 5%. Perhaps if the Fed only raised the Fed Funds rate to 3% to maintain the average 2% spread, the economy wouldn’t have collapsed as badly.
Below is a closeup chart of the S&P 500, the Fed Funds rate, and the 10-year bond yield.
The Bond Market Knows Better Than The Federal Reserve
Now that you’ve got a good understanding of interest rates, you can see how vacuous a statement it is when someone tells you to buy property before interest rates (referring to the Fed) go up and vice versa.
The Fed Funds rate could easily raise rates while the 10-year bond yield might not budge. Who is generally right? The seven Board of Governors on the Federal Reserve or the $100+ trillion bond market with thousands of domestic and international investors?
Of course the market knows best. The Federal Reserve has consistently shown policy errors in the past. They raised rates when they shouldn’t have. Or, they’ve conducted a surprise cut when they shouldn’t have. Or, they kept rates too low for too long or kept rates too high for too long.
Foreign Buyers Of U.S. Debt
Given the United States is considered the most sovereign country in the world, our assets are also considered the most stable. As a result, China, India, Japan, Europe are all huge buyers of US government Treasury bonds. As a result, their financial destinies are tightly intertwined with ours.
Let’s say China and Japan go through hard landing scenarios. International investors will sell Chinese and Japanese assets/currency, and buy U.S. Treasury bonds for safety. If this happens, Treasury bond values go up, while bond yields go down.
The U.S. has foreigners hooked on our debt because U.S. consumers are hooked on purchasing international goods, most notably from China. The more the U.S. buys from China, the more U.S. dollars China needs to recycle back into U.S. Treasury bonds.
From a capital account perspective, China certainly doesn’t want interest rates to rise too much in the US. If they do, their massive Treasury bond position will take a hit. As a result, US consumers will spend less on Chinese products at the margin.
Thank goodness we’re all in this together. I expect to see foreign buyers buy up U.S. property in the coming years.
You Want The Federal Reserve On Your Side
Although the Federal Reserve doesn’t control mortgage rates, you want the Federal Reserve to be on your side. As an investor, an accommodating Federal Reserve is huge. Just look how the Fed helped investors during the entire global pandemic.
The Federal Reserve can be on our side by publicly stating they are carefully observing how various events may negatively affect the economy e.g. the coronavirus. The Federal Reserve can also be on our side by not letting the spread between the 10-year Treasury yield and the Fed Funds rate grow too big.
A tone deaf Fed gives investors zero confidence. At the same time, investors want a Federal Reserve who will show strength and leadership during times of chaos.
The Fed announced it will be hiking the Fed Funds rate three times in 2022 and three times in 2023. But the 10-year bond yield didn’t go up after the lates 2021 announcement.
In other words, the bond market believes the Federal Reserve will be making a mistake if it raises that many times in this two-year window. And usually, the bond market is right.
There is no clearer example of the Federal Reserve not controlling mortgage interest rates than when mortgage rates went down AFTER the Federal Reserve said it would be hiking the Fed Funds rate in December 2021.
Be At Least Neutral Real Estate
Now that you know the Federal Reserve does not control mortgage rates, what now? I recommend everybody be at least neutral the property market by owning your primary residence. Being neutral the property market means you are no longer a victim of inflation given your costs are mostly fixed.
You can’t really profit from the real estate market, unless you sell your house and downsize. You don’t really lose either, so long as you can afford the house, since you’ve got to live somewhere.
The only way you can gain confidence of owning your property for 10 or more years is if:
- Positive about your career company’s growth prospects
- Bullish about your own career growth and talents
- Got 30% or more of the value of your property saved up in cash or liquid securities (e.g. 20% down, 10% buffer at least)
- You love the area and can see yourself living there forever
- You’ve got rich parents, relatives, or a trust fund to bail you out
Strategically Invest In Real Estate
Real estate is my favorite asset class to build wealth. During times of uncertainty, real estate offers more asset price stability and a more predictable income stream. Stocks provide higher returns on average, but stocks are also a lot more volatile and don’t provide any utility.
If you’re looking to buy property as an investment or reinvest your house sale proceeds, take a look at Fundrise, one of the largest real estate crowdfunding platforms today. Fundrise enables investors to invest in a diversified real estate fund with just $10.
In addition, take a look at CrowdStreet. CrowdStreet is for accredited investors who want to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations and higher rental yields. 18-hour cities usually have higher growth due to job growth and demographic trends. If you have a lot more capital, you can build you own diversified real estate portfolio.
Why The Federal Reserve Does Not Control Mortgage Interest Rates is a Financial Samurai original post. I have been investing in real estate since 2003 and have over a $10 million real estate portfolio. I’ve invested $850,000 through real estate crowdfunding so far to diversify my holdings away from expensive San Francisco real estate.