The Disconnect Between Federal Reserve Rate Cuts and Mortgage Rates
Often misunderstood, there is a significant distinction between the Federal Reserve rate cuts and the movement of mortgage rates. In this article, we will clarify the relationship between them and explain why the Federal Reserve's actions do not directly impact mortgage rates, at least in the short to mid-term.
Understanding the Relationship: The Federal Reserve and Mortgage Rates
The Federal Reserve, through its Federal Open Market Committee (FOMC), adjusts the target for the Federal Funds Rate. This adjustment can influence the prime rate, which in turn affects other consumer interest rates. However, it is crucial to note that mortgage rates are not directly influenced by these changes.
Mortgage Rates Determined by Mortgage Backed Securities (MBS)
Mortgage rates are primarily determined by the current price of Mortgage-Backed Securities (MBS). These are bonds comprised of pools of residential mortgages, purchased by investors such as Fannie Mae and Freddie Mac. Mortgage lenders sell their funded loans to these investors, making a small profit on the transaction.
The price of MBS fluctuates based on market conditions. These conditions are influenced by a wide range of factors, including the Federal Reserve's announcements about future monetary policy and inflation expectations. However, the direct impact of the Federal Reserve's rate cuts is minimal in the short to mid-term.
A Historical Look at MBS Prices
To illustrate this, let's examine a chart of MBS prices from August 2, 2024. Higher MBS prices correspond to lower mortgage rates. On September 18, 2024, the Federal Reserve announced a 0.50 rate cut. However, there was little to no immediate reaction in the MBS market:
This chart clearly shows that while the Federal Reserve cut rates, the MBS market did not react significantly, indicating that the relationship is not straightforward.
The Impact of Quantitative Easing (QE)
A notable exception to this is when the Federal Reserve implemented Quantitative Easing (QE). During this period, the Fed purchased mortgage bonds at a rate of 80 billion per month and MBS at 40 billion per month. This direct intervention brought mortgage rates down to below 3.0% for 30-year fixed-rate loans, providing a significant stimulus to the housing market and the economy as a whole.
However, the beneficial impact of QE was tempered by the ongoing shortage of housing inventory, which limited the overall impact on the market.
Taking a Closer Look at the Mechanisms
The Federal Reserve's rate cuts signal to the market their expectations for future inflation. This information is factored into the pricing of MBS and other securities. However, the actual rate at which mortgages are sold is independent of the Federal Reserve's immediate rate adjustments.
Investors in MBS prioritize risk-free investments such as 10-year Treasury bonds. Since mortgages have inherent risk, they are priced with a premium of approximately 2% above the 10-year Treasury rate. To understand where mortgage rates are heading, one should follow the 10-year Treasury rate.
Conclusion: The Limitations of Federal Reserve Influence on Mortgage Rates
While the Federal Reserve plays a crucial role in shaping the overall economic environment, its direct influence on mortgage rates is limited. Therefore, if you are interested in predicting mortgage rate movements, focus on the 10-year Treasury rate and overall market dynamics rather than the Federal Reserve's short-term rate adjustments.
Understanding this relationship can help investors and borrowers make more informed decisions in the mortgage market.