It's A Good Time To Review The Correlation Between Fed Funds And Mortgage Rates

Here is a common question over the past few weeks:

“If rates were cut .500%, is my 30 year fixed going to be .500% lower?”

The answer is different than you may think, and while I do agree that we tend to see declining interest rates in mortgages when the Federal Reserve is in the cut-side of the rate cycle, the subtle relationship between Fed Funds and Mortgage Rates needs to be understood if you are engaged in a purchase or refinance transaction involving money borrowed from a bank. Failure to understand this means you may get caught on the wrong side of a timing bet.

Remember “Fed Funds” is the rate that banks can borrow money from each other to keep their reserve amounts in line. The “Discount Rate” is the interest rate at which an eligible financial institution may borrow funds directly from the Federal Reserve when their reserves dip below the reserve requirement. It's considered the last resort for banks, which usually borrow from each other. The Federal Reserve can change either – but they can’t change mortgage rates!

Check out this chart for an illustration. You'll notice some basic tendencies that are similar, but by no means is there a basis point to basis point connection. In fact, when the Fed cuts rates, there is often a spike in mortgage rates based on the perceived threat of inflation associated with lower borrowing costs at the institutional level. Mortgage rates are based on long term fixed income investment vehicles, aka bond instruments, which hate inflation. Inflation eats away at the value of that income over time.

Looking back at the markets when the Fed threw in a surprise .750% rate cut, I believe it was the news about the rogue trades made by Societe Generale to the tune of MINUS 7.1 BILLION DOLLARS that caused the Fed to throw in the emergency towel and caused domestic money to pile into safe fixed income investments – like mortgage bonds. This pushed mortgage rates down quickly. It was not the Fed action directly causing mortgage rates to improve, but both were reacting to the same news in their own way for different reasons. In the days that followed, the mortgage bonds quickly reversed and went the other direction, suggesting that the Fed action ultimately caused rates to worsen when you look at the net of the 2-7 days that followed the news... Again, lower Fed rates invites inflation, arch enemy of fixed investments.

This does not mean that I expect to see rates rise steadily as the Fed continues this cutting cycle - and I expect to see the Fed go another 100 basis points over the coming year. Mortgage rates will also come under pressure based on the same economic data that the Fed is responding to. The important lesson here is to understand that the Fed is trying to achieve balance between price stability and economic growth. Cutting rates threatens price stability by inviting inflation. But raising rates to fight inflation chokes off growth. This is why they constantly tamper with the Fed Funds rate. The bond market reacts to their policy decisions and jumps back and forth based on how effectively it views the Fed to be at maintaining that balance.

It may not be simple to understand. But if you are in a mortgage transaction, or about to consider one, you best make sure that you're working with a professional who gets this. Waiting to lock because we expect the Fed to cut rates has been bad advice at every single cut since the Fed began easing in this cycle.