Between 2H2018 and 1H2019, something funny happened. The Federal Reserve was raising their Fed Funds rate, yet mortgage rates kept on falling. This article explains why this happened. Hint: The Fed is not always right.
Despite the Fed raising interest rates methodically since late 2015, mortgage rates have actually gone nowhere during this time period.
First, let’s look at the Fed Funds rate chart since end of 2015. The hikes have been steady and quite steep based on where we came from.
Now let’s look at various mortgage rate terms since 2015. Notice how the average mortgage rates for a 30-year fixed, 5/1 ARM and 15-year fixed are all back to where they were at the end of 2015.
Why aren’t mortgage rates increasing along with the rise in the Fed Funds rate?
The simple answer is that the Fed does not control mortgage rates. The bond market via bond investors do.
The Federal Reserve sets the overnight lending rate (Fed funds rate), which determines how expensive it is for banks to lend money to each other on overnight transactions.
This short-term rate helps determine money market rates, checking account rates, short-term CD rates, and even egregious credit card rates. For example, you can now get a healthy 1.75% money market rate whereas back in 2015, the best you could do was around 0.25%.
Mortgage rates, on the other hand, are influenced by the 10-year US Treasury bond, which is determined by the market, not the Fed.
So What Do Low Interest Rates Mean For Investors?
On the one hand, low bond yields mean that the opportunity cost for not holding bonds is low. Therefore, investors are more inclined to invest in stocks, especially if the S&P 500 dividend yield is higher than the 10-year Treasury bond yield.
Just imagine if the 10-year Treasury bond yielded 10%. You may not be inclined to risk as much money in the stock market because the 10% is a guaranteed annual return if you hold the 10-year bond to maturity. That said, if the 10-year bond yield is at 10%, it likely means there is rampant inflation due to massive wage pressure and accelerated corporate earnings. In this scenario, stocks may very well return much greater than a risk-adjusted 10% a year.
Declining mortgage rates also means more people can afford homes. The real estate market is unlikely to collapse under a wave of mortgage defaults because the credit quality of mortgage borrowers has drastically increased since the financial crisis.
The average FICO score for an approved mortgage is over 720, and you no longer have NINJA loans that don’t require any money down. Those adjustable rate mortgages that are resetting today aren’t going to see a large uptick at all. Meanwhile, homeowners who missed the massive refinance window before November 8, 2016, have another chance to lock in a low rate at record lows in 2020 thanks to the coronavirus-induced market meltdown!
On the other hand, investors should be a little worried that despite all signs pointing to a healthy economy, so many investors are choosing to buy US Treasury bonds for only a ~2.2% annual yield. The logic goes, if the economy is so awesome, why wouldn’t you sell bonds and buy as many risk-assets as possible to get as rich as possible? What does the bond market know that we do not know?
The answer lies in still benevolent inflation figures and FEAR. Anybody who has been investing for the past 20 years or longer has seen boom bust cycles come and go. Everything seemed hunky dory in 2007 when the unemployment rate hovered at only 4.5% and the S&P 500 consistently returned double digits for years. Then everything fell apart.
You never know when sentiment will turn, but when it does, the fall is always quicker than the rise due to the fear of losing everything. Low interest rates means more leverage. More leverage means more violent destruction on the downside. Therefore, it’s better to sell risk-assets in an appreciating market. Even though you won’t catch the top, it’s much better than trying to sell in a declining market when the demand floor drops out from under you.
Stocks, bonds, cryptocurrencies, and coastal real estate are all expensive today. As a result, I’m not adding to any of my positions at the moment, but instead, deleveraging by paying down mortgage debt and raising my cash balance. My immediate goal is to take profits in one of my SF rental properties and redeploy the proceeds into cheaper middle America real estate. Real estate rose to ~40% of my net worth after I purchased another home in 2014, and I’d like to get the figure down to a more conservative 25%.
I wish the good times can last forever. Heck, even Fed Chair Janet Yellen said on June 27 that she doesn’t believe there will be another financial crisis for at least as long as she lives, thanks largely to reforms of the banking system since the 2007-2009 crash. Let’s hope Yellen lives a very long life then! Because the way the Fed is hiking short-term interest rates, the yield curve will flatten and eventually help cause another recession.
* Ignore people in the real estate industry who say, “Buy now before interest rates get too high!” or “Refinance now because interest rates are rising!” They don’t understand interest rate fundamentals.
* If the short end of the yield curve (Fed funds rate) rises faster than the long end (10-year bond yield), the yield curve will flatten. A flattening yield curve means investors are not being compensated for holding longer-term securities largely due to muted inflationary expectations and greater fear of the future. A flattening yield curve can sometimes be a signal for an upcoming recession.
* Pay attention to national inflation and unemployment rates. These are the two figures the Fed focuses on the most. The Fed targets an unemployment rate of between 4.7% – 5%, and an inflation rate of 2%. If inflation comes in much higher than 2%, the Fed will have a tendency to raise interest rates more aggressively. With the current unemployment rate at roughly 4.3%, the Fed is anticipating wage pressure growth, which ultimately leads to higher inflation. Now pay attention to your local employment figures.
* Never confuse brains with a bull market. Arrogance is wealth-destroying. Try not to fight the Fed or the government either. The Fed wants to enrich asset owners at the expense of non-asset owners. The government, with its pro-housing rules, wants every American to own a home. But sometimes, things get out of control. Look towards lower valuation, higher yielding properties in the heartland of America instead. I’ve personally invested $810,000 with real estate crowdfunding to take advantage of much cheaper real estate away from the coasts.
Recommendations To Build Wealth
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Refinance your mortgage. Check out Credible, one of the largest mortgage lending marketplaces where lenders compete for your business. You’ll get real quotes from pre-vetted, qualified lenders in under three minutes. Credible is the easiest way to compare rates and lenders all in one place. Take advantage of lower rates by refinancing today.
Updated for 2020 and beyond.