A look into my mortgage-rate crystal ball

Anyone associated with real estate saw that the Federal Reserve did not raise rates at their meeting in March. At their recent meeting, they implied they intend to increase rates later this year. How is this possible that mortgage rates will not increase substantially?  Ironically, the fed claimed they would raise rates, yet mortgage rates fell.

First, it is important to note that the Federal Reserve does not directly control mortgage rates. The Fed controls the “federal funds rate”. The federal funds rate is the rate at which banks and credit unions lend reserve balances to other banks and credit unions overnight. In a nutshell this is the rate banks get on the money they are holding in cash/reserves. Here is a more detailed explanation.

So how are mortgage rates set? Unfortunately, mortgage rates are not “set”. There is no government or private party that can set rates per se. Mortgage rates are typically based on the 10-year treasury yield. So how does this work?

Before discussing rates, it is important to understand how bond yields work. The most important piece of this equation is the relationship between a bond price and its return. For treasuries, it is critical to note that a bond price and its yield move in inverse. What this means is that a higher bond price results in a lower yield and vice versa.

With this key piece of information, we can now understand why mortgages do not move in direct correlation with the federal funds rate. This became apparent when the Federal Reserve raised rates in December. Within a few weeks, mortgage rates had dropped below when rates started. How can this happen?

In the example above, there was a flight to quality assets with the financial global turmoil. When there is a flight to quality (aka people desire to put their funds in high-quality liquid assets like treasuries for whatever reason), it ultimately drives bond prices up and therefore yields down, so mortgages remain low.

So why am I convinced yields will stay low (prices will stay high on bonds)? There are a number of reasons. First, the international uncertainty will keep demand for treasuries high (think China’s market gyrations or Europe’s negative interest rates which were noted in the Federal Reserve’s press release). This international uncertainty has driven a demand for one of the most stable/safe assets, treasuries. Based on supply and demand, as there is more demand, prices will increase.

Second, the Fed is very nervous about raising rates. With almost every other developed country lowering rates to stimulate their economy, the Fed would counteract these measures if it acted too quickly. The majority of trade throughout the world is conducted in dollars, as the Fed raises rates, the dollar becomes stronger, which will hurt many economies and also hurt anyone exporting from the US (stronger dollar means US goods are more expensive).

Third, the Fed states that they are data-driven, and due to the sharp decline in commodities, US inflation has been mediocre. The economy is also just putting along at a slow pace. This view was reinforced earlier this week when the labor report came out and showed no average increase in wages. The most recent consumer spending index was also revised downward as consumers made fewer retail purchases.

Long and short, look for rates to hang out in record low territory for a bit longer. The Federal Reserve will act in a measured fashion going forward. They have realized that the paradigm has shifted where their policies now impact the rest of the world. This is a heavy weight since the Federal Reserve must now take into account global repercussions of their policies before acting.