The Fed is not raising/cutting mortgage rates directly

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A quick bit of housekeeping before we dig into the headline: Mortgage rates are slightly higher so far this week. The increases were in place Monday. Tuesday started stronger, but most lenders returned to Monday’s levels after bonds lost ground throughout the day. Bond prices/yields are the most important input for mortgage rates.

With that in mind, we’re even more equipped to talk about the Fed’s announcement tomorrow. There is a common misconception that the Fed “fixes” (or raises/lowers) mortgage rates directly. Even among the most knowledgeable people, there is often a belief that changes in the fed funds rate (what the Fed actually raises/lowers) translates directly into changes in mortgage rates.

Nope…

The Fed meets 8 times a year to discuss monetary policy changes. Excluding unscheduled emergency meetings, these represent the 8 chances the Fed has to raise or cut the fed funds rate.

What is the federal funds rate?

The federal funds rate is a target set by the Fed for interest charged by large banks for lending money to each other on an overnight basis. It has several policy tools that ensure the target is reliably met within a quarter percent margin (one of the reasons the Fed communicates rate targets in 0.25% windows).

In other words, the Fed “decides” (for lack of a better term) what shorter-term loans will cost. From there, the market decides the cost of longer-term loans. While the federal funds rate is for loans that last 24 hours or less, the average mortgage lasts 3 to 10 years depending on the real estate and mortgage environment at any given time in history.

The only potential exception for the Fed to directly set mortgage rates would be certain lines of credit based on the PRIME rate (which changes with Fed hikes/cuts). This is a large minority of the mortgage market and nothing like the dominant 30 year fixed loan.

So why do rates sometimes react so much to Fed announcements?

The Fed may not set mortgage rates directly, but they can still say/do things that have a huge impact on all kinds of interest rates. One of the most notable examples is that of QE or Quantitative Easing. It was/is the Fed’s policy of buying Treasuries and mortgage-backed securities in large quantities in an effort to promote its policy goals. Changes in QE policies – especially when unexpected – have a much greater impact on long-term rates than the short-term fed funds rate.

I thought you said the fed funds rate didn’t matter, but you just implied it had an impact. Which give?!

Yes, the fed funds rate absolutely has an impact on longer-term rates like mortgages. And yes, the Fed is definitely raising/cutting the fed funds rate. But the catch has to do with timing.

Remember that the Fed only meets 8 times a year but the market trades every millisecond. Traders won’t wait for the Fed to pull the trigger on a rate hike if they can be reasonably sure it will happen. Indeed, there are entire groups of market securities devoted to betting on the Fed Funds rate in the future (incidentally called “Fed Funds Futures”).

These futures typically price in most upcoming Fed rate hikes/cuts with nearly 100% accuracy. It hasn’t always been the case, but it’s increasingly common in an era of extremely transparent speeches by Fed members. For example, if 7 out of 7 Fed speakers over the past month have all mentioned that they are leaning towards a 0.75 hike in the fed funds rate, that is essentially guaranteed and the bond market has long since changed to result.

Since the market may show up to the party long before the Fed itself, it’s not uncommon to see mortgage rates moving in the opposite direction of the Fed on the day the Fed actually acts.

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