What Happens to Mortgage Rates When the Fed Changes Rates? Part 2
Let’s start by looking at the graph from the previous article, that of 10-year Treasury bond yield and the Discount Rate that the Fed sets.
You can see that in the first year bond yields, and mortgages too, by the way, fell over one percent. At the same time, the Fed was actually raising rates. Certainly there was no correlation there. In fact, if you just followed what the Fed was doing, you would have missed out when mortgage rates were falling. No help there.
You might next conclude that what was happening in the long-term bond market might have actually had an impact on the Fed, not the other way around. At the point marked “A” on the graph, when rates had been falling for a year, the Fed started cutting rates. The Discount Rate went from a high of 6.5% all the way down to 1% percent, a huge drop.
If there were a connection to long-term rates we ought to see it here, right? But no, bond yields traded in a narrow range for this entire period. When the Fed finally got through its initial round of cutting, point “B” on our chart, the Discount Rate was at 1% and the 10-year bond yield was about 4.5%, only about ½% below where it was in late 2000.
That doesn’t mean that there wasn’t a lot happening. When the 10-year bond yield fell below 5% people started refinancing. Bond yields continued to fall, finally breaking below 4 percent in October 2002; by that time we were in a full-blown refinance boom that lasted a long time.
In mid-2004, the Fed started to raise rates and did so for 17 consecutive meetings of the FOMC. They stopped in mid-2006 at point “C” on our graph. You can see that the yield on the 10-year bond was virtually the same as it was when they started. So here’s the Fed raising rates from 1% to 5.25%, a huge increase, and it has zero effect on long-term rates. Are you shocked?
In mid-2007, long-term rates started to fall again. It was at this point that there was a shock to the financial markets brought on by an acknowledgement that the subprime mortgage mess was going to take a heck of a toll on the economy. You read the information in the papers about billions of dollars in losses and CEOs losing their jobs.
You can see that rates fell another 1% but it wasn’t until September, several months later, that the Fed started responding. Again, it looks to me as if the Fed responds to these changes rather than causes them. As I write this in January 2008, the yield on the 10-year bond has fallen even more, to 3.8%, and the Fed is about to meet. A little late?Now, for those who have any lingering doubts, let’s go back to mid-September 2007 when, probably, a hundred thousand people or more held off locking in their loans “until the Fed lowers rates,” as was widely expected. Instead of the ¼% rate cut the Fed Watchers expected, everyone got a bit of a surprise because the Fed dropped the Discount Rate ½%, twice as much.
All of those folks who thought that they knew the pattern were probably elated to see the large drop, and when they called their lenders, they expected to hear that mortgage rates were ½% lower too.
You can see the wide gyration late in the day when the Fed made their announcement. You can also see that the rate jumped about 16 basis points or .16%.
Mortgage rates responded on the upside too and were up about .25 percent pretty much across the board. All of those people who had been waiting for a cut got an increase instead -- the perils of ignorance. They should have locked in their loans the day before, and their failure to do so cost them more than they thought they were going to save.So I hope by now that we have put the nail in the coffin as to any relationship between what the Fed does and long-term rates. But that leaves a big question: What do mortgage rates correlate with? We’ll cover that in the next article.
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