What Happens to Mortgage Rates When the Fed Changes Rates? Part 1
The most dangerous profession in the world is trying to predict the future. Experts don’t seem to be able to do it, yet ordinary people sometimes think they can forecast interest rates. They say things like, “I’m not going to refinance until after the Fed lowers rates when they meet next week.”
There is a reason for this behavior. Scientists who study brain function tell us that man’s early survival was based in part on recognizing patterns that helped find food and avoid danger. To this day we still do the same thing. We subconsciously look for patterns. If we think that there is one, we act on it. Some people believe there is a pattern to interest rates. Are they right?
I don’t think it is unreasonable for people to think that there is a connection between mortgage rates and what the Fed does, but this belief JUST HAPPENS TO BE WRONG. There is no correlation -- no pattern -- that can be relied upon.
The Federal Reserve Board affects interest rates by the actions of its Open Market Committee, FOMC for short. That Committee establishes the Discount Rate and sets a target for the Federal Funds Rate. The Discount Rate is the rate at which banks can borrow directly from the Fed. The Federal Funds Rate is the rate that banks pay when they lend each other money.
A lot of different interest rates, notably the Prime Rate that banks charge their customers, are directly related to these rates, so a large number of people watch the Fed’s actions closely. There is even a name for these people: Fed Watchers. These people are kind of like the people who divine the future by looking at chicken innards.
Quite honestly, in my 45-year business career, I have never seen anything useful or helpful resulting from Fed Watchers, but that same thing may rightly be said of almost everyone back in Washington D.C.
Back to the topic at hand: There are those who believe that Fed Watchers are actually able to divine the future. There are those who make bets with other peoples’ money on what they think might happen. I always wonder if they risk any of their own money at the same time.
Let’s assume that you are buying a home or refinancing one and that you are trying to figure out when to lock in the rate. Let’s also assume for the moment that, just this once, when the information is valuable, YOU really can forecast the future: today you KNOW what the Fed is going to do in a couple of weeks.
Before you take action, however, you will want to look at the historical relationship between the Discount Rate that the Fed sets and the yield on 10-year Treasury bonds that closely follow mortgage rates. Here is a graph of those data from January 2000 to December 2007.
We’ll get into a detailed analysis of this chart in the next article, but spend a little time looking at this and see if you can find anything that would make you believe that there is a connection.
You can draw your own conclusions from this chart, but my interpretation, if there is any correlation, is that the Fed has acted after the bond market has told it something about what it thought about the economic prospects -- not the other way around. Specifically, I see no evidence whatsoever to justify the belief that the Fed has any immediate impact on mortgage rates.
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