Fed Rate Cut & Mortgage Rates???

Posted by Mitch Argon / CalNeva Realty on Friday, October 5th, 2007 at 10:31am.

[[This post is provided by Scott Storace of Guild Mortgage.]]
 
On September 18th, the Federal Reserve Bank cut the federal funds rate by 50 basis points or one-half percent. They also cut the federal discount rate by the same amount. Following these cuts I received many phone calls from borrowers and real estate agents who were trying to understand how the news would affect mortgage interest rates. To understand this one has to understand short-term and long-term rates, as well as, bonds and inflation.
 
The Federal Reserve Board defines the discount rate as “the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility--the discount window.” Simply put, the discount rate is the rate that the Federal Reserve Bank charges commercial banks and institutions for borrowing money for a short-period of time. Usually, these loans are to meet short-term liquidity issues or to resolve severe financial difficulties. The federal funds rate is different. The FRB defines this rate as “the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.” This is the rate that banks earn for temporarily lending their money to other banks. These are both short-term interest rates, usually from one day to six months.
 
However, mortgage rates are mainly long-term. These rates are defined as being anywhere from 10 to 30 years and are largely determined by the ten-year U.S. Treasury bond rate. The Federal Reserve Board does not control the long-term interest rates, only the short-term rates. Therefore, the Federal Reserve Board has no direct impact on mortgage rates. So, you’re probably wondering who does. The answer is investors! Investors in the Fannie Mae and Freddie Mac bonds are the ones who directly affect the price of mortgage rates. Fannie Mae and Freddie Mac are for-profit companies that loan money for residential home purchases. In order to get their money back, they package these mortgages as bonds and sell them to investors. The rates on these bonds must be good enough to entice investors worldwide to buy them. It’s the buying and selling of these bonds that triggers rates to move up and down daily. Basically, bond investors are hedging against inflation. They are making a long-term evaluation that rates will exceed inflation. If they purchase a bond for 6% interest and inflation goes to 7%, then they’ll be losing 1%. Currently, rates are roughly 6.25% and inflation is around 2%. Therefore, investors are getting a 4% spread. So, bond purchases and sales are inflation driven. Inflationary concerns are bad news for bonds and drive the price down. To understand this better it helps to visualize a teeter-totter with bonds on one-side and mortgage rates on the other. Bonds and mortgage rates have an inverse relationship. When bond prices are down, mortgage interest rates go up. However, when ten-year U.S. Treasury bond prices increase, mortgage rates typically go down.
 
So, when the Federal Reserve Board cut their short-term interest rates two weeks ago, many people were surprised to see mortgage rates go up. This happened due to long-term inflationary concerns. So, to understand where mortgage rates are going you must follow the ten-year U.S. Treasury bond prices and understand what affects inflation. Inflation is simply growth. Bond investors are afraid of too much growth. We see inflation and deflation of prices every day from the gas that we purchase to the food that we eat and the cars that we drive. Remember the house that your parents purchased for $70,000 that’s now worth $250,000. The difference in price is the cause of inflation, or growth. Growth in what you may be asking yourself? Growth in jobs, growth in wages, growth in manufacturing, growth in home sales and growth in retail sales are some of the factors that lead to inflation. When the economy is growing companies earn more money. When companies are more profitable the returns of the stock market are greater. Employees benefit from growth in their 401k plans, higher wages and greater benefits. This leads to consumer confidence which spurs retail sales, home sales, car sales and increased sales of just about everything else. Greater demand for goods and services puts pressure on the supply of those goods and services which forces the sellers to raise their prices. The increased cost of goods reduces individual and corporate profits. With less money to spend, companies and individuals pull back and the economy shrinks. This is how a basic market cycle works. It’s the same old story of supply versus demand, up markets versus down markets.
 
Today, we’re experiencing a tighter market. Consecutive short-term rate hikes by the Fed in past years cooled the sizzling growth of the economy. With the economy effectively cooled, the Fed’s recent decision to reduce short-term rates is the first step towards growing the economy once again. But remember that the next time the Fed adjusts short-term rates it does not mean that we’ll see an adjustment in mortgage interest rates. There is no direct correlation between the two. You should get a feel for inflation, watch the bond pricing or simply call me. I watch the markets daily and stay abreast of the direction that bonds, and mortgage rates, are heading.
 
For more information on the Nevada loans and mortgage rates, you please visit Scott online or call him at 775-781-5464.
 
If you are looking for any help with buying or selling a home in Greater Reno-Tahoe, please see my site for more information.
 
Cheers!
 
Mitch
Mitch Argon
Broker - CalNeva Realty

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