Last week the Federal Reserve raised its benchmark Federal Funds rate 0.250% to 1.500% to 1.750%. The Federal Funds rate is a key interest rate that impacts the cost of borrowing for many financial institutions including banks and mortgage lenders. When the Fed increases interest rates, mortgage rates typically increase as well but that did not happen last week. In fact mortgage rates were flat or even down for most lenders following the Fed’s announcement. How could mortgage rates actually fall if the Fed raised interest rates and what does this mean for borrowers?
Last week’s events teach us several important points about mortgage rates. First, one of the most important determinants of mortgage rate pricing is market expectations. The Federal Reserve had forecast its interest rate hike for several months so lenders were not surprised by the news. Most mortgage lenders had already factored in the Fed’s rate increase into their mortgage rate pricing before the Fed’s official announcement, which helps explain the response, or lack thereof, by mortgage rate. It is safe to assume that mortgage rates would have reacted differently if the Fed had raised interest rates by more than a quarter point or if they significantly changed their forecast for future rate increases, because this outcome would have been much different than what the market expected.
It is also important to realize that Federal Reserve has more policy tools at its disposal than the Federal Funds rate. For example, the Federal Reserve has the ability to purchase securities in the open market to help implement policy mandates. During the great recession, the Fed purchased billions of dollars of mortgage backed securities and other debt products to help support the mortgage market and keep rates low. While the Fed has stated its intention to “unwind” its balance sheet and sell down its portfolio of mortgage backed securities, it may also buy mortgage backed debt from time to time to stabilize the market. In other words, the Fed may be operating behind the scenes to prevent a rapid rise in interest rates.
A final point to highlight is that while the Federal Reserve is a very important factor in determining mortgage rates, it is not the only factor. Other inputs like bond pricing, treasury yields, the stock market and other economic indicators also significantly influence mortgage rates. For example, the day after the Federal Reserve’s announcement, the stock market plunged in response to concerns over a potential trade war with China. Investors sold stocks and bought bonds and treasuries, which caused yields on those securities to go down. Bond and treasury yields are one of the key inputs to mortgage rate pricing so when yields decline, mortgage rates typically decline or remain steady at worst. So in essence, mortgage borrowers can thank trade tariffs for helping to keep mortgage rates low.
Last week’s events remind us that in the near term, mortgage rates are unpredictable. The Fed raised rates, yet mortgage rates were flat-to-down. Market expectations, bond yields and a multitude of other factors can cause changes to mortgage rates on a daily or even sometimes an hourly basis. On any given day, mortgage rates may or may not respond to the Federal Reserve’s actions.
Over the long term, however, mortgage rates tend to move in the same direction as the Fed. So while we may have been surprised that mortgage rates dipped slightly last week, it was likely only a temporary reprieve. With the Fed reiterating its forecast of at least two more rate hikes in 2018 and potentially four rates hikes in 2019 we should expect rates to continue to rise over the course of the next twenty months, even if they occasionally dip along the way like they did last week.
Although there are no guarantees with mortgage rates, the Federal Reserve usually wins in the long run. The next time the Fed raises interest rates, we may not be able to count on a potential trade war to hold mortgage rates down. Given this dynamic, prospective home buyers and borrowers looking to refinance may benefit by acting sooner rather than later.