Ever wondered why your mortgage interest rates don’t always follow the Federal Reserve’s rate cuts or hikes? Well, it’s because the Fed doesn’t directly control mortgage rates – the bond market does. This market is influenced by bond investors, including retail, institutional, and sovereign investors.
The Fed’s rate changes do have an impact on long bond yields, but they don’t control the entire movement of mortgage rates. There are many factors at play here. For instance, in the first quarter of 2022, the Fed started increasing interest rates to combat inflation. After 11 rate hikes, mortgage rates shot up.
Here’s a breakdown of what caused a 5% increase in mortgage rates, from 3% to 8%:
- 2.5% was due to the Fed’s policy rates, accounting for 50% of the mortgage rate increase.
- 0.8% was due to the expansion of the Term premium, making up 16% of the increase.
- 0.8% was due to prepayment risk.
- 0.3% was due to inflation.
- 0.4% was due to OAS spread.
- 0.3% was due to Lender Fees.
The Fed controls the Fed Funds Rate (FFR), an overnight interbank lending rate. This rate affects short-term lending rates like credit card interest rates and short-term car loan rates, but not so much the longer-term mortgage rates.
Mortgage rates are influenced more by longer duration U.S. Treasury bond yields. For example, when the Fed slashed its FFR to 0% – 0.25% in the first quarter of 2020, mortgage rates actually increased because US Treasury bond yields went up by about 0.5%. This was partly due to Congress approving a major spending package to mitigate the economic impact of the coronavirus, which led to an increase in government debt and, consequently, higher yields.
The Fed controls the FFR, which is the rate banks use to lend to each other, not to individuals. The central bank’s role is to keep inflation at a reasonable level while aiming for full employment. Banks are required to keep a minimum reserve with the Fed or in their own vaults, and they can lend any surplus over this minimum at the effective FFR to other banks with a deficit, and vice versa.
The Fed’s main goals are to keep inflation under control (targeting a ~2% Consumer Price Index) while keeping the unemployment rate as close to the natural rate of employment as possible (4% – 5%). Today, inflation is high, which means the Fed is on a mission to hike the FFR until inflation cools down.
Inflation isn’t necessarily bad if it’s steady at around 2% per year. But when it starts rising to 10%, 50%, 100% or more, things can get out of control. Inflation can be particularly hard on families as it can lead to higher housing, medical, and education costs.
In 2022, fears of inflation grew as the US inflation rate rose past 4%, 6%, then 8%, and ultimately peaked above 9% in June 2022. It’s now back down to about 6% for the end of the first quarter of 2023 and will be closely monitored for the rest of the year.
The Fed determines the FFR, but it doesn’t determine mortgage rates. Instead, the bond market determines the 10-year Treasury yield, which is a major factor in determining mortgage rates.
The Fed has made policy errors in the past, such as raising rates when it shouldn’t have, conducting a surprise cut when it shouldn’t have, or keeping rates too low or too high for too long. The bond market, with its thousands of domestic and international investors, usually knows better.
If you’re looking to refinance your mortgage, it’s better to follow the Treasury bond market rather than the Fed. The bond market can give 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 US is considered the most sovereign country in the world, and our assets are also considered the most stable. As a result, countries like China, India, Japan, and Europe are all huge buyers of US government Treasury bonds. Their financial destinies are tightly intertwined with ours.
The Fed doesn’t control mortgage rates, but as real estate and stock investors, you want the Fed to be on your side. An accommodating Fed is a huge advantage for investors.
Now that you know the Fed doesn’t control mortgage rates, what should you do? I recommend owning your primary residence to at least be neutral in the property market. This means you’re no longer a victim of inflation since your costs are mostly fixed.
Mortgage rates are expected to start trending lower by 2024 given the decline in inflation since June 2022. I expect the average 30-year fixed rate mortgage to decline from 7% in 2023 to 5.5% in 2024 and 5% in 2025.
Real estate is a great way to achieve financial freedom. It’s a tangible asset that’s less volatile, provides utility, and generates income. I’ve invested in real estate crowdfunding platforms to diversify my holdings and earn more passive income.
In conclusion, the bond market, not the Fed, determines mortgage rates. So, if you’re thinking about refinancing your mortgage or buying property, it’s better to follow the Treasury bond market rather than the Fed.
