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How federal fund and mortgage rates differ

The federal funds rate, which is the rate the feds have been cutting lately, is the overnight interest rate which banks charge each other when a bank needs to borrow money to meet end-of-day reserve requirements. A bank must have a certain amount of cash on hand when the books close at the end of the day, and those funds can be borrowed from another bank. The Fed’s merely suggest what that rate should be, but banks negotiate the true rate.

The fed’s discount rate is a guideline for short-term lending. It would be an unfair financial instrument in which to tie mortgage rates, as mortgages are typically long-term.

The immediate impact of a fed “target rate” or fed funds rate reduction will be lower rates on credit card debt, auto/boat loans and home equity loans. The Federal Reserve does not determine mortgage rates – the Bond Market does in most cases. The 10-year Treasury Bond is the relevant benchmark for determining appropriate values of a mortgage loan. Mortgages are bundled and sold as bonds to investors who seek fixed income investments. This is referred to as the “secondary mortgage market.”



So what drives the 10-year bond?

Bonds have an interest rate (yield) and a selling price. When bond prices are up, bond yields are down, and thus, mortgage rates are down as they move with bond yields. But what makes bonds go up or down?




Inflation is the primary factor that affects the Treasury bond markets and mortgage rate levels. The one thing Treasury bond investors don’t like is inflation because it diminishes the value of their fixed-return investments. When the economy slows down and inflation is subdued, investors become more comfortable investing in long term debt and the Treasury bond rallies – bond yields go down as do mortgage rates.

30-year mortgage rates are impacted by the supply and demand of funds available for long-term loans. We’ve recently been in a situation where the fed is busy cutting the fed funds rate, but investors are increasingly stressed by inflation forecasts and are not rallying at Treasury Bond auctions which is affecting liquidity.

For years I’ve been telling clients: “When you hear bad news – national or global – call me. I’m the ‘bad news bear’ because frequently bad news translates to lower rates.” All markets react strongly to catastrophes – markets don’t like uncertainty. Fixed rate investments gain luster when there is bad news as investors flock to safety and away from stocks.

When there is a wave of negative economic news and disturbing news about capital markets here and overseas the fed is compelled to react to calm the markets. When the Federal Reserve makes a dramatic move, as they’ve done recently by lowering the discount rate several times in a couple of weeks, they are sending a message to the financial markets that “all is well.”

The big mystery in all of this is timing. What many people don’t realize is that markets are constantly looking at a myriad of conflicting information and pricing into the market what the future will look like long before the public has read the news stories. By the time we’re reading about recession, recovery, stagflation, inflation, etc., the markets have already priced in how the Federal Reserve or stock market is going to react. So frequently we will see bond yields and mortgage rates drop in advance of a Federal Reserve rate cut and actually bounce back after the news of the cut is released.

Susan Costello is owner of Home Sweet Home Loans, dba Empire H.L.C. in Grass Valley. You may reach her by calling (530) 273-8658.


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