Ever wonder why mortgage interest rates sometimes don’t decrease when the Federal Reserve cuts interest rates and vice versa? The simple answer is that the Fed does not control mortgage interest rates. The bond market does.
The Federal Reserve controls the Fed Funds Rate (FFR), which is an overnight interbank lending rate. An overnight rate is the shortest lending term, which means shorter duration lending rates such as credit card interest rates and short-term car loan interest rates will be affected.
However, mortgage rates have longer duration lending terms. Therefore, longer duration U.S. Treasury bond yields have a far greater influence on mortgage interest rates than the FFR.
The Fed Doesn’t Control Mortgage Rates
After the Federal Reserve slashed its Fed Funds Rate to 0% – 0.25%, mortgage rates actually went up because US Treasury bond yields went up by ~0.5%.
The increase came about partly as a result of Congress’ approval of a major spending package aimed at curbing the economic impact of the coronavirus, as well as discussions of a broader, more expensive stimulus package now known as the CARES Act.
The plan will require a large amount of government debt to be issued, in the form of U.S. Treasuries. Knowing that more bonds will be in the market, current Treasuries suddenly warranted lower prices, which resulted in higher yields.
Mortgage rates and Treasury bond yields also went up after the emergency rate cut because of the negative signaling by the Fed. If the Fed couldn’t wait three days to cut rates during its policy meeting, then things must be really bad. As a result, investors indiscriminately sold everything to raise cash.
Finally, mortgage rates went higher after the Fed cut the FFR due to expectations for higher prepayments which degrades investor returns and creates high gross supply of Mortgage Backed Securities.
The Federal Funds Rate is the interest rate everybody is referring to when discussing cutting or increasing interest rates. The FFR is the interest rate that banks use to 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, much like 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 (net interest margin).
If a bank has a surplus over its minimum reserve requirement ratio, it can lend money at the effective FFR to other banks with a deficit and vice versa. A lower effective FFR rate should induce more inter-bank borrowing which will be re-lent to consumers and businesses to help keep the economy liquid.
This is exactly the outcome the Federal Reserve had hoped for when it started to lower interest rates in September 2007 as the economy began to head into a recession.
Study the historical Effective Federal Funds Rate chart below.
By the summer of 2008, everybody was freaking out because Bear Sterns had been 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. But when it did, however, that’s when the real panic began.
What happens when everybody freaks out? Banks stop lending and people stop borrowing. This is what economists call “a crisis of confidence.” Consequently, the Federal Reserve lowered the FFR in order to compel banks to keep funds flowing. Think of the Federal Reserve as attempting to keep the oil flowing through a sputtering car engine.
Inflation And Unemployment
The Federal Reserve’s main goals are to keep inflation under control (~2% Consumer Price Index 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 and injects too much liquidity, inflationary pressure might build up due to too much economic activity.
Inflation isn’t bad if it runs at a steady 2% annual clip. It’s when inflation starts rising to 5%, 10%, 50%, 100%+ that things get out of control because you might not be able to make enough to afford future goods or your savings lose 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 precious metals. Before the pandemic, owners of health care, child care, elder care, and higher education businesses also significantly benefitted as you can see from the chart below.
Everybody else is a price taker who gets squeezed by higher rents, higher tuition, higher food, higher transportation and so forth.
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. As a result, the rate of inflation will eventually decline.
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, despite massive stimulus, to worry about inflation during a global pandemic is unnecessary because unemployment is skyrocketing. Instead, we should be more worried about deflation.
Fed Funds Rate And Our Borrowing Rates
The Federal Reserve determines the Fed Funds Rate. The market determines the 10-year Treasury yield. And most importantly, the 10-year Treasury yield is the predominant factor in determining mortgage rates.
There definitely is 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. While there have definitely been times where both rates have spiked higher between 2% – 4% within a five-year window, however, the dominant overall trend is down due to knowledge, productivity, coordination, and technology.
This long-term trend down is one of many reasons why I believe taking out an adjustable-rate mortgage mortgage with a lower interest rate will likely save you more money than taking out a 30-year fixed-rate mortgage.
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, in the future, it is unlikely the Fed will raise the Fed Funds rate by more than 4%.
2) The Fed is running out of ammunition to cut rates. During the past two downturns, the Fed was willing to cut rates by up to 5% to help spur the economy along. With the current effective FFR at 1.25% – 1.5% in 1Q2020, the Fed no longer has the same amount of impact.
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.
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.
6) 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, which portends to a recession within 18 months if the Fed doesn’t aggressively cut rates.
Take a look at what happened between 2004 and 2010. The spread between the 10-year yield and the Fed Funds Rate was around 2%. The Fed then raised the FFR to 5% from 1.5% until it burst the housing bubble that it had helped to create. The FFR and the 10-year yield reached parity at 5%. Perhaps if the Fed had maintained the average 2% spread and only raised the FFR to 3%, the economy wouldn’t have collapsed as badly.
Below is a closeup chart of the S&P 500, the FFR, and the 10-year bond yield.
The Bond Market Knows Better
Now that you’ve gotten a better understanding of how the Fed Funds Rate and mortgage rates work, you should no longer automatically assume such things as:
- It’s time to refinance my mortgage now that the Fed cut rates.
- Better to refinance now before the Fed raises rates.
- Better to wait until the Fed cuts rates before refinancing my mortgage.
- Time to buy real estate now that the Fed has slashed rates.
- Time to sell real estate and other assets now that the Fed is hiking rates.
The Federal Reserve could easily raise the FFR while the 10-year bond yield might not even 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?
The market usually knows best. The Federal Reserve has consistently made policy errors in the past where it has raised rates when it shouldn’t have, conducted a surprise cut when it shouldn’t have, kept rates too low for too long, or kept rates too high for too long.
The Federal Reserve is trying its best to forecast the future. However, consistently forecasting the future is hard. Therefore, you might as well follow the real-time bond market to see what it’s telling us.
It is the Treasury bond market that gives us a better glimpse of the future. For example, when the yield curve inverts, history shows that there’s a high likelihood of a recession within 18 months of inversion.
The bond market had been screaming at the Fed to aggressively cut the FFR for a year before it finally did. Thankfully, the bond market also gave equity investors who had been paying attention, ample time to reduce equity exposure.
See: Understanding The Yield Curve: A Prescient Economic Indicator
You Want The Federal Reserve On Your Side
Although the Federal Reserve doesn’t control mortgage rates, as real estate and stock investors, you absolutely want the Federal Reserve to be on your side.
The Federal Reserve can be on our side by publicly stating it is carefully observing how various events may negatively affect the economy. The Federal Reserve can also be on our side by not letting the spread between the 10-year Treasury yield and the FFR rate grow too large.
A tone-deaf Fed gives investors zero confidence. At the same time, investors want a Federal Reserve that shows strength and leadership during times of chaos. Always being reactionary instead of being proactive is an ineffective Federal Reserve.
If you want to refinance your mortgage, follow the Treasury bond market. If you follow the Fed, you’ll likely always be one step behind.
What’s Going On With Mortgage Rates Today?
Thankfully, the irrational selling of Treasury bonds is now over. The jump in mortgage rates actually helped lenders since they were getting crushed by demand. Now that mortgage rates are back down, I expect refinancing activity to pick up aggressively again while we shelter-in-place in April.
If you missed out on trying to refinance during the crazy volatility in March 2020, I would try again. Although many lenders probably still have a backlog, mortgage rates should be lower as the 10-year bond yield plummets again.
Check out the best lending platform today, Credible, for free online quotes and then call your bank to see if they can match or beat. Both have a team of qualified lenders looking to compete for your business. The more competitive quotes you can get, the better.
Mortgage rates are back down to all-time lows. Time to take advantage and save some money!
I had an application with better at the same time started in mid -Feb. At the end of Feb it appeared the rate became unlocked and we suddenly had $12k in points when it was previously a credit. They said that shouldn’t have happened and they would fix it, but never did despite several follow up calls. (That’s when I turned to Credible, as the rate was slightly better). I never cancelled with better, and was glad when the credible loan fell through last week. Yesterday Better told me the change in fees (credit to $12k in points) was because the lender changed from Citi to TIAA and there was nothing they could do. Today they are telling my the TIAA loan is being denied because we don’t meet employment verification guidelines (I’m going to follow up as I’m curious, we’ve had the same jobs for more than 2-4 years) and they will be refunding our appraisal fee.
I’m locked again with a bank this time not a mortgage broker, but we’ll see how it goes.
This is crazy. Have you been hearing stories like this from any other readers?
We have excellent credit, only debt is the mortgage and a partner share, about a million in assets and we’re employed in fairly high paying jobs as MD/PhD, in the Bay Area.
Just crazy right now.
Question for Sam and readers, I’d really love some feedback on this:
I have a Co-op in Manhattan (I’m currently renting a house in Charleston until the pandemic is over), apartment is worth roughly 650k, with 420k remaining on the mortgage. We have a 10 year ARM at 3.375%, fixed rate ends 2027.
Long term I’m not sure if we will keep the property or sell if we need to get something larger. Or if we decide to buy larger in another city, we will likely hang on to this property long term and keep as a rental until retirement.
Thoughts on refinancing to a 30 yr fixed, vs a new 10 yr ARM to buy us 3-4 more years of a fixed rate?
Much appreciated!
I prefer the 10/1 ARM. 7 more years of the fixed rate is a long time. Seems like you can just keep it for a while and reconsider in several years.
See: https://www.financialsamurai.com/why-an-adjustable-rate-mortgage-is-better-than-a-fixed-rate-mortgage/
I’ve been looking at listings in Charleston, SC while stuck down here. I’m considering putting in some low ball offers in this market as now may be a good time to find a distressed seller. If it make sense I may refi the Co-op to pull our some cash for a down payment on a property in Charleston.
Totally agree wrt watching the bond market vs the stock market. I managed to sell at almost the top. And of course talking to my friends in China realized how bad it was going to get.
In fact I’m still surprised at the current stock market levels. Want to invest at the bottom but that would be harder to predict.
Great explanation btw wrt FFR, 10 yr, mortgage rates. With the Fed getting aggressive I wonder if this would still hold. Wouldn’t be surprised if the Fed follows BoJ and just buys stocks.
Hi All,
I wanted to share our recent experience. My family are first time home buyers with excellent credit scores. On March 16th we were offered a par rate of 3.375% for 30 year fixed VA rate and an opportunity to cut it to 2.75% by purchasing 0.93 points.
Another point I would like to share is we were able to find a lender who did not require impounds. There is a big misconception about impound and VA backed loans. 99% of lenders will require it. However, in my research it is 100% up to the lender whether those impounds will be included in your loan.
We are in California and found a mortgage broker while we contacted quite a few. Only two “knew of one lender who did not require impounds”.
We are in California as well and are considering a VA refinance. Can you share the name of the lender that does not require impounds? Thanks!
The way I understand it there is a commercial side such as a brand-name bank and a wholesale side. In order to reach the wholesale side you have to go through a broker. The wholesale lender is United wholesale mortgage. If the broker does not have an account with them then they cannot do business with them.
Definitely considering a refinance right now. Even though I have had my mortgage only two years with $74,000 (out of $90,000) remaining, I’d be remiss to keep paying 4.125% APR. I would only do a no cost refinance, as even a mere eighth of a percent reduction of interest would result in at least $69/month in savings.
The only PITA is finding a lender that deals with co-ops. So so SO many restrictions! It was such a pain getting the mortgage in the first place!
Great write up on what moves mortgage rates, Sam. Even I get confused with this stuff.
Sincerely,
ARB–Angry Retail Banker
For clarification, the Fed does determine the 30yr mortgage rates now. Last week they purchased 50 bln a day in agency MBS, some of it for T+1 settle. For context, in the 08/09 crisis they bought 10 bln a day and always for regular settle, never short settle. This is why mortgage rates have moved lower recently. Separately, mortgage originators/servicers are uncertain how to operate in this environment. Will they be expected to front mortgage payments for investors while homeowners are in forbearance. How will they manage the losses they likely incurred this month on their TBA hedges as home purchases fell through. How do you refinance if your location can’t do online notaries?
I got my 7/1 jumbo ARM (with usual costs) at 2.5% from BoA. BoA also lowers your rate if you bring in assets to Boa or Merrill Lynch (0.125% reduction for each 250k brought in).
This was a few months ago, before the march panic.
hi aj,
Is this 15 year or 30 year ARM? This is really competitive rates!
Tim,
This is my employer’s credit union, which is a major international development bank. You have to be an employee or family members to join it. Their CD is very very low rates, but mortgage is relatively good, especially the arm products (the fixed ones are just so so).
I was told yesterday, even those ‘no cost’ option, I still need to pay about 1000 for lender title insurance (which I can shop for) plus prepaid interest/property tax for six month and one month of mortgage payment. So for my remaining 570k balance, I still need to bring about 7,000 at closing.
Does that make sense to you?
See: https://www.financialsamurai.com/all-the-mortgage-refinance-fees-in-a-no-cost-refinance/
Sam, I just closed 2.625% on a 15yr, I grabbed it during the March panic.
Sounds good to me!
I’m locked in on a 30 year 3.25% with about $3K in closing costs (this was prior to the influx of re-fi demand and the perfect time according to my lender). Everything that I’ve recently found on the ARM side doesn’t seem that attractive, including on Credible. Am I missing something?
ARMs should be closer to 2.75% or lower if your 30-year is at 3.25%. However, there’s been a lot of prepayment risk in the MBS market, which is causing pricing to be higher than normal. Lots of disruption going on, so you’ve got to keep on checking.
Can you ELI5 why prepayment is considered a risk in the MBS?
In my head (simplifying as much as I can), if I lend $10 dollars to be paid over 30 years, I’m expecting to get around $16 dollars back. If instead the borrower paid it all back in 8 years, I’ve collected mostly on interest and can use that prepayment to now hand out $12 dollars in loans. So I don’t get why prepayment would be considered a risk.
Is it considered a risk because giving new loans increase the default risk?
Sure. You buy a $100 mortgage for $20. You hope it pays $3 for at least 7 years. When rates go down, prepayment risk goes up bc the mortgage holder will want to refinance.
The price to buy your mortgage goes from $20 down to $7.
Thank you!
I used Lending Tree per FS’s suggestion in late Feb. I have yet to re-finance because every lender who has called me is still quoting rates above 4% even for 5-year ARMs. My credit score is over 800, I own multiple properties, and my net worth is down only 6% since mid Feb so I don’t understand why lenders are offering me such raw deals.
Guess I will continue to wait…
[The reason I am down only 6% is my aversion to diversification. I prefer to put most of my eggs in one basket and watch it like a hawk. I am mostly invested in Amazon. I do not work for the company but I live near Seattle and have plenty of friends who work there which helps me keep my finger on the pulse.]
Surprising they are still stuck at over 4%. I’d call your existing bank to see what they have to offer. I think Credible just got their license for Washington state.
Nice job on Amazon. The rich get richer! I’m a fellow Amazon shareholder as well, but don’t have a large stake.
Such important points you highlight in this post! Especially helping people understand the difference in the Federal Funds Rate and Treasuries.
“ This long-term trend down is one of many reasons why I believe taking out an adjustable-rate mortgage mortgage with a lower interest rate will likely save you more money than taking out a 30-year fixed-rate mortgage.”
Really important point above too. This is something I hope more people will take into consideration so they can hopefully save more money.
Thanks for always providing so many important financial lessons and writing so timely!
Always a fantasy markets.
Fed does not control the rates but market does. That market is made up of people. Those people who Fed should hire but they can’t because Fed sucks. And those chaps are smart.
I guess we will never know who is fooling whom. And if there is a winner amongst all this?
I feel better about my 5/1 ARM @3% that has an adjustment in 11 months
Not sure if you should wait. There is a fat bird in the bush right now. If you can do a no-cost refinance at a lower rate, I would like it in right now.
Then again, I don’t think mortgage rates are going to rise anytime soon with a global pandemic.
OK, I’ll try calling around again. I think I saw the other day that LIBOR was at 0.75%, which means my ARM would remain at 3%.
In my favor, I also have $200k from my 401(k) from employer I left in September. I could offer to roll that over to whoever I refinance with, which could help negotiate a better rate.
Hi Sam, the recent quote from my credit union on no cost refinance is:
3/3 arm 30 years: 2.725
1/5 arm 30 years: 2.85
1/7 arm 30 years: 3
I’m hesitating between these 3. Which one do you recommend?
Thank you!
Those are all relatively good rates for no-cost. What mortgage rate do you have now?
I would match the fixed duration with how long you plan to own the home or how long you plan to keep a mortgage.
I refinanced to a 7/1 ARM because I don’t plan to keep my mortgage for longer than seven years.
I’m currently on my second year of 7 arm 30 years at 3.625%. Those rates are from my credit union.
I plan to hold on the property between 3-7 years whenever it’s good time to sell. That’s why I’m not sure which one to choose!
Thank you for replying!
I’d go 5/1 ARM for 2.875% then. Feels psychologically good to be under 3%!
Marie, those #’s are really good for a no cost refinance, what is the name of the credit union that you are working with? plus are their some of the other accounts/assets that you currently have with them to get those rates?