Question of the week: How does the Federal Reserve impact mortgage rates?
Long time readers of the WR&MU know I mention the Federal Reserve, aka the Fed, a lot in updates, usually in the section covering news of the week that impacts mortgage rates. Whenever the Fed changes rates I usually get inquiries from different sectors of my life as to what it means for mortgage rates. This week the Fed raised its Federal Funds Rate by 0.25% and at two different meetings subsequent to the rate increase I had conversations regarding what it means for mortgages.
Before we cover the impact that the Fed has on mortgage rates let’s cover what rates the Fed does impact directly. There are two interest rates that are directly associated with the Federal Reserve and the Fed does not directly control either. The Federal Funds Rate is the rate at which member banks charge each other for over-night loans so they can cover their required minimum reserves, the Federal Discount Rate is the rate at which the Fed loans money over-night to member banks so they can cover their reserves.
What reserves? Depending on its size a bank in the United States must retain either 10% of their total deposits (banks with more than $122.3 million in deposits) or 3% of their deposits (banks with $16 to $122.3 million in deposits) in their banks. If a bank slips below this requirement due to making loans that total more than the either 90% or 97% that can be out in loans, the bank must borrow money to add to its reserves to meet the requirement. The bank can either go to the Fed’s discount window and borrow the needed funds, or it can borrow the funds from another bank that has reserves above the reserve requirement. Depending on whether it goes to the discount window or another bank will be determined by the rate each is charging.
How are those rates set? The Federal Reserve sets the rate it charges at the discount window, and this changes daily based on the market, demand and objectives of the Fed as to what it wants to do with its assets—loan them out to member banks or retain them for its own reserves. The rate that gets all the publicity is the Fed funds rate, the rate banks charge each other to lend money over-night.
This week the Fed was in the news and it was reported that the Open Market Committee of the Federal Reserve (aka the FOMC) raised the Fed funds rate by 0.25% (one-quarter of one percent). So to the casual observer with some knowledge of the Fed the presumption is that the Fed is telling its members that it must increase the rate it charges other banks to borrow money over-night by 0.25%. Somewhat accurate, but not entirely. What the FOMC announces when it “increases” rates is the target rate it would like to see banks charging each other, but the actual rate is determined by supply and demand each night and what lending banks are willing to charge and what member banks are willing to pay.
Confused? Example: Fred’s Bank at the close of the day has $150 million in deposits, but only $15 million in reserves on hand, it is short $1 million to meet the reserve requirement. Fred’s Bank’s reserve requirement manager goes on-line and sees the Fed is willing to lend the million dollars over-night at a rate of 2.25% (the Fed discount rate), the manager then checks the member bank website and sees that Jane’s Bank, which also has $150 million in deposits but $19 million in reserves, or $4 million above the requirement, is willing to lend one million dollars over-night for 2.23% under the Federal Funds agreement between member banks. The manager at Fred’s Bank can save 0.02% borrowing from Jane’s bank and initiates the transaction. In reality the amount borrowed over-night is in the billions, tens of billions so the savings for small differences such as 0.02% become pretty big.
The only rate set by the Fed is the discount rate it charges for over-night loans, but it influences the funds rate by making a strong suggestion to member banks as to what rate it would like see them use for making over-night loans. The two are usually very close, but again determined by the market.
Back to our question, how does the Fed impact mortgage rates?
As you can see there is no consumer rate that the Fed manages or dictates. However, but by impacting the rate at which banks can borrow money it is also impacting the rate at which banks will loan money to consumers. If a bank can make enough loans so that it is constantly below the reserve requirement, borrow money from the Fed at 2.25% to cover the required reserves and then lend the money it is borrowing at 2.25% to clients at say 5.25% it is making 3% on the money it is borrowing.
The 5.25% in my example is what the current prime rate is after the Fed rate increase last week. This impacts homeowners with Home Equity Lines of Credit directly, and the increase in the prime rate was a direct result of the action by the Fed’s Open Market Committee to raise its target for the funds rate.
However, long term mortgage rates, the 30-year fixed rate the majority of borrowers obtain, is not impacted by the FOMC decision. Directly.
Indirectly, the Fed’s move impacted mortgage rates months ago. And the current actions, and statements, by the Fed are impacting future mortgage rates. How?
Mortgage rates are determined by the open market. Investors, and think hundreds of billions of dollars daily, have many choices to make that balance their desire for high returns for their funds and minimizing risk that those funds will decline in value due to the wrong investment decision. Investors are also gamblers. They are constantly research the economy, markets, industries and hundreds of other factors with the sole objective of trying to predict what will happen tomorrow, next week, next month and next year. Based on their information they make the decision to invest in equities, aka stocks, which means you own part of a company; or fixed rate assets that pay a specified rate of return for a specified period like bonds, or mortgages.
The most basic piece of information to determine whether to invest in equities or bonds is information that shows how the general economy is doing. If the economy is doing really well, or looks like it will be doing really well, money will go into stocks, causing stock prices to increase, and money will go out of bonds and rates will go up. Why? If the economy is doing well companies will earn more money and therefore be worth more in the future, investors are buying today, low, and looking to sell in the future, high. They leave fixed rate assets like bonds because as the economy improves rates will increase so the rates they are fixing today by buying a bond will be worth less money in the future after rates increase. Conversely, if it appears the economy is slowing down, or contracting, investors will sell equities as companies will be earning less or be losing money in the future, and buy fixed rate invests instead locking in higher rates today with the presumption rates will decline as the economy declines; the higher rates they lock into today will be worth more money in the future when rates are lower.
Example: Investor reads the economic tea leaves and sees a growing economy. The option is to purchase a fixed rate investment paying guaranteed 4% for the next five years, or purchase a shares in a mutual fund that focusses on growth. Based on the economy growing, rates will increase so in one or two years the same fixed rate investment may be 5% or higher, or 25% more than the current return, but the money would be locked in at 4%, missing out on the opportunity for the higher rate of return. The mutual fund with companies that experience growth in strong economies is expected to return 6-7% over the next one or two years. If the investor is correct the money will be invested in the mutual fund, and then in a year or two the decision will be made with that money to either sell the mutual fund and re-invest in fixed assets now paying over 5% or leave the money in the fund. Because the 4% fixed rate is not enough to attract investors to invest the rate will increase until investors are attracted.
Move ahead two years and the economic growth is losing, or has lost, steam. Rates have gone up to encourage investors, which has also been a factor in slowing economic growth. The investor has made an average of 6.5% by investing in the growth fund but sees the economy has slowed. Looking at the markets there is a fixed rate bond that is guaranteed to pay 6.25% for the next five years. Knowing a bad market will cause rates to decline, and also slow the growth of companies, the investor sells the growth fund holdings and purchases the fixed rate bond. As the economy does slow down the investor is collecting a higher rate of return on the fixed asset than newer bonds coming to market are paying, as well as a lot more than the growth fund that is now losing value.
The Fed indirectly impacts mortgage rates as it provides a look into the future for investors as to which way interest rates are headed, often by broadcasting in advance its future intentions with rates. The rate increase last week had no impact on mortgage rates because the Fed told the world in 2017 its intention to increase rates through 2018, how often and by how much. We know that the Fed will increase its target for the funds rate by December 31st by another 0.25%, if it does then there will be no impact on mortgage rates as investors have already priced this increase into bonds and mortgages. If however, the target is increased by 0.50% instead of 0.25% mortgage rates will jump as the rate increase was higher than expected and investors will have been caught off-guard and will sell off holdings they purchased anticipating only a 0.25% increase.
What impacts mortgage rates is the expectation for what rates will be in the future. What rates will be in the future is determined by economic activity. This is why I include a brief economic report every week in the WR&MU, so readers can get an idea of the strength, or weakness, of the economy and from that get a good idea if rates will be going up, going down, or holding steady.
Even with economic activity it is still somewhat of a guessing game as at any time rates can bounce up or fall down based on national or international events. The rule of thumb for mortgage rates is bad news means low rates and good news means high rates.
I hope this was not too much deep in the weeds in describing the Fed’s impact on your mortgage rate, but it is hard to make a simple explanation on a somewhat complex issue.
Have a question? Ask me!
First Friday means jobs. On the First Friday of every month the Labor Department releases the labor statistics for the prior month. Today’s release contained a huge headline number that will cause a stir and details that need further examination. The important data is that non-farm payrolls increased by 134,000 for the month, well below the expectations of 168,000 and below the average of over 200,000 new jobs for month for the first nine months of the year. It is unknown if the lower than expected number of new hires was impacted by Hurricane Florence, or if it is signifying a slow-down in hiring that will continue. Employers are having a hard time finding workers, as indicated by the headline unemployment rate dropping 0.2% from August to 3.7%, the lowest unemployment rate since December 1969. Wages grew 0.3% for the month and are up 2.8% from last August. The news is not positive for rates. With unemployment dropping employers will need to continue to increase wages to fill vacancies, which will in turn require prices to increase to cover the higher labor costs. This can start a wage and price inflation spiral that can be difficult to control. This leads to expectations for higher rates, which puts very strong upward pressure on interest rates.
Rates for Friday October 5, 2018: Several months ago, I wrote about the Fed selling off its accumulation of mortgages and U.S. Treasury bonds it purchased over the years following the recession. At the same time these assets are hitting the market the U.S. Treasury is also selling short and long term debt to finance the operations of the government. With increased supply on the market, which drives down prices and rates up, plus economic data indicating there is a strong possibility of higher inflation, and therefore higher rates, it is not surprise that the U.S. Treasury 10 year bond yield is at its highest since July 2011 and that 30-year fixed mortgage rates today hit their highest levels since April 2011. There is some over-reaction from investors this week to the employment data, however when they make adjustments to their behavior, any decrease in rates will be much more modest than the increase we have seen since the end of August. Now is the time to lock in your mortgage rates.
FIXED RATE MORTGAGES AT COST OF 1.25 POINTS LOCKED FOR 45 DAYS:
30 year conforming 4.875% Up 0.25%
30 year high-balance conforming 5.125% Up 0.125%
Please note that these are base rates and adjustments may be added for condominiums, refinances, credit scores, loan to value, no impound account and period rate is locked. Rates are based on 20% down with 740 FICO score for purchase mortgages.
Thanks to my wonderful wife Leslie, PR consultant extraordinaire, and her terrific team, my website is fully functional and includes past Weekly Rate & Market Updates through 2016. The posts from 2016 and 2017 will see some changes, hopefully over the weekend, as I tighten up the titles. The posts from this year are listed by date and also show the Question of the Week to help visitors find topics they are interested in learning more about. There is still some cleaning up and beautifying to go but I am excited that archives of past updates are now available.
Thank you to everyone who got back to me on last week’s topic regarding the Propositions on the California ballot in November, it was the most feedback I have had on a Question of the Week in some time. If you missed it click here.
Have a great week,