The Federal Reserve Doesn’t Control Mortgage Rates

Ever wonder why mortgage interest rates sometimes don’t decrease when the Federal Reserve cuts interest rates and vice versa? The simple answer is that the Fed does not control mortgage interest rates. The bond market does. However, the Fed’s rate hikes do influence where the long bond yield goes.

The Federal Reserve controls the Fed Funds Rate (FFR), which is an overnight interbank lending rate. An overnight rate is the shortest lending term. This means shorter duration lending rates such as credit card interest rates and short-term car loan interest rates will be affected. Not so much longer-term mortgage rates.

However, mortgage rates have longer duration lending terms. Therefore, longer duration U.S. Treasury bond yields have a far greater influence on mortgage interest rates than the FFR.

The Federal Reserve Doesn’t Control Mortgage Rates

After the Federal Reserve slashed its Fed Funds Rate to 0% – 0.25% in 1Q 2020, mortgage rates actually went up because US Treasury bond yields went up by ~0.5%.

The increase came about partly as a result of Congress’ approval of a major spending package aimed at curbing the economic impact of the coronavirus, as well as discussions of a broader, more expensive stimulus package now known as the CARES Act.

The plan required a large amount of government debt to be issued, in the form of U.S. Treasuries. Knowing that more bonds will be in the market, Treasuries suddenly warranted lower prices, which resulted in higher yields.

The Federal Reserve Doesn't Control Mortgage Rates

Mortgage rates and Treasury bond yields also went up after the emergency rate cut because of the negative signaling by the Fed. If the Fed couldn’t wait three days to cut rates during its policy meeting, then things must be really bad. As a result, investors indiscriminately sold everything to raise cash.

Finally, mortgage rates went higher after the Fed cut the FFR due to expectations for higher prepayments which degrades investor returns and creates high gross supply of Mortgage Backed Securities.

The Federal Reserve Controls The Fed Funds Rate

The Federal Reserve controls the Federal Funds rate. It is the interest rate everybody is referring to when discussing cutting or increasing interest rates. The FFR is the interest rate that banks use to lend to each other, not to you or me. The role of central bankers is to keep inflation at a reasonable live while they aim for full employment.

There’s generally a minimum reserve requirement ratio a bank must keep with the Federal Reserve or in the vaults of their bank, e.g. 10% of all deposits must be held in reserves. Banks need a minimum amount in reserves to operate. This is much like how we need a minimum amount in our checking accounts to pay our bills. At the same time, banks are looking to profit by lending out as much money as possible at a spread (net interest margin).

If a bank has a surplus over its minimum reserve requirement ratio, it can lend money at the effective FFR to other banks with a deficit and vice versa. A lower effective FFR rate should induce more inter-bank borrowing which will be re-lent to consumers and businesses to help keep the economy liquid.

This is exactly the outcome the Federal Reserve had hoped for when it started to lower interest rates in September 2007 as the economy began to head into a recession.

Study the historical Effective Federal Funds Rate chart below.

Historical Fed Funds effective rate
Historical Fed Funds Rate Chart

By the summer of 2008, everybody was freaking out because Bear Sterns had been sold for a pittance to JP Morgan Chase. And then on September 15, 2008, Lehman Brothers filed for bankruptcy. Nobody expected the government to let Lehman Brothers go under. But when it did, however, that’s when the real panic began.

What happens when everybody freaks out? Banks stop lending and people stop borrowing. This is what economists call “a crisis of confidence.” Consequently, the Federal Reserve lowered the FFR in order to compel banks to keep funds flowing. Think of the Federal Reserve as attempting to keep the oil flowing through a sputtering car engine.

Then, we all know too well what 2020 brought – the global pandemic. With fears of a recession, the Federal Reserve conducted an inter-meeting rate cut of 50 basis points in March. And by April 2020, they cut rates again, all the way down to 0.05.

The Fed Funds Rate hovered near zero for about two years. Then finally in spring 2022, Fed rate hikes resumed and are expected to continue in 2023 to the 5.25-5.50% range. Time will tell.

Inflation And Unemployment

The Federal Reserve’s main goals are to keep inflation under control (~2% Consumer Price Index target) while keeping the unemployment rate as close to the natural rate of employment as possible (4% – 5%). Today, inflation is elevated, which means the Fed is on the mission to hike the Fed Funds rate until inflation is cooled.

The Federal Reserve does this through monetary policy – raising and lowering interest rates, printing money, or buying bonds to inject liquidity into the system. They did a commendable job since the financial crisis. However, if the Federal Reserve lowers interest rates for too long and injects too much liquidity, inflationary pressure might build up due to too much economic activity.

Is Inflation Bad?

Why is inflation bad? Inflation isn’t bad if it runs at a steady 2% annual clip. It’s when inflation starts rising to 10%, 50%, 100%+ that things get out of control. In such a scenario, you might not be able to make enough to afford future goods or your savings lose purchasing power at too fast a pace. Or you simply can’t properly plan for your financial future.

Inflation fears erupted in 2022 as the US inflation rate rose past 4%, 6%, then 8%, and ultimately peaked above 9% in June 2022. It’s back down to about 6% for the end of 1Q 2023 and will be monitored closely for the remainder of the year.

The only people who like inflation are those who own real assets that inflate along with inflation. These assets generally include stocks, real estate, and precious metals. Before the pandemic, owners of health care, child care, elder care, and higher education businesses also significantly benefitted.

Everybody else is a price taker who gets squeezed by higher rents, higher tuition, higher food, higher transportation and more.

Inflation chart by category

Inflation Is Great For Investors

During boom times, when employers are hiring aggressively and wage growth is increasing above CPI, the Federal Reserve may need to raise interest rates before inflation gets out of control.

By the time inflation is smacking us in the face, it may be too late for the Fed to be effective since there’s generally a 3-6 month lag in monetary policy efficacy.

Higher interest rates slow down the demand to borrow money, which in turn slows down the pace of production, job growth and investing. As a result, the rate of inflation will eventually decline.

If the Federal Reserve could engineer a 2% inflation figure and a 3.5% unemployment figure forever, they would. Alas, the economy is always ebbing and flowing.

As a result, the housing market should stay strong for years to come. Rents and real estate prices are going to continue going up and to the right. It behooves us to responsibly invest in more assets like real estate.

Record unemployment claims during coronavirus global pandemic in the U.S.

Fed Funds Rate And Our Borrowing Rates

The Federal Reserve determines the Fed Funds Rate. The Federal Reserve does not determine mortgage rates. Instead, the bond market determines the 10-year Treasury yield. And most importantly, the 10-year Treasury yield is the predominant factor in determining mortgage rates.

There definitely is a correlation between the short duration Fed Funds Rate, and the longer duration 10-year yield as you can see in the chart below from Advisor Perspectives/VettaFi.

S&P 500 vs 10 yr Treasuries, FFR and Recessions Chart - The Fed Doesn't Control Mortgage Rates

The first thing you’ll notice is that the Fed Funds rate (red) and the 10-year Treasury yield  (blue) have been declining for the past 40+ years. There have definitely been times where both rates have spiked higher between 2% – 4% within a five-year window. However, the dominant overall trend is down due to knowledge, productivity, coordination, and technology.

This long-term trend down is one of many reasons why I believe taking out an adjustable-rate mortgage mortgage with a lower interest rate will likely save you more money than taking out a 30-year fixed-rate mortgage.

Information From the Chart

1) From 1987 – 1988, the Fed raised rates from 6% to 10%. From 1994 to 1996, the Fed raised rates from 3% to 6%. From 2004 to 2007, the Fed raised rates from 1.5% to 5%. In other words, it has seemed unlikely the Fed will ever raise the Fed Funds rate by more than 4% in the future. However, the Fed is expected to continue raising rates in 2023 up to the 5.25%-5.50% range after the 2 year flatline. Time will tell if this more aggressive raising will be beneficial or not.

2) The Fed may run out of ammunition to cut rates. In prior downturns, the Fed would be willing to cut rates by up to 5% to help spur the economy along. When the effective Fed Funds rate was at 1.25% – 1.5% in 1Q2020, they could not make as large of an impact.

3) The longest interest rate up-cycle or down-cycle is about three years once the Fed starts raising or cutting rates.

4) The 10-year yield doesn’t fall or rise by as much as the Fed Funds Rate. I explain why in my article on why mortgage rates don’t drop as fast as treasury yields.

5) The S&P 500 has generally moved up and to the right since its beginning. The steepening ascent corresponds to the drop in both interest rates since the 1980s.

6) The average spread between the Fed Funds Rate and the 10-year bond yield has been over 2% since the 2008 – 2009 financial crisis. However, the spread aggressively inverted in 2020. This portended to a recession. We may experience a repeat of this in 2023.

Spreads Between The 10-Yr Bond Yield And FFR

Take a look at what happened between 2004 and 2010. The spread between the 10-year yield and the Fed Funds Rate was around 2%. The Fed then raised the FFR to 5% from 1.5% until it burst the housing bubble it helped create.

The FFR and the 10-year yield reached parity at 5%. Perhaps if the Fed had maintained the average 2% spread and only raised the FFR to 3%, the economy wouldn’t have collapsed as badly.

Below is a closeup chart of the S&P 500, the Fed Funds rate, and the 10-year bond yield.

S&P 500 and Fed FFR intervention - The Fed Doesn’t Control Mortgage Rates, The Market Does
The S&P 500 and Federal Reserve Intervention

The Bond Market Knows Better Than The Federal Reserve

Now you have a better understanding of how the Fed Funds Rate and mortgage rates work. You can see how vacuous a statement it is when someone tells you to buy property before interest rates (referring to the Fed) go up and vise versa. You should no longer automatically assume such things as:

  • It’s time to refinance my mortgage now that the Fed cut rates.
  • Better to refinance now before the Fed raises rates.
  • Better to wait until the Fed cuts rates before refinancing my mortgage.
  • Time to buy real estate now that the Fed has slashed rates.
  • Time to sell real estate and other assets now that the Fed is hiking rates.

The Federal Reserve could easily raise the FFR while the 10-year bond yield might not even budge. Who is generally right? The seven Board of Governors on the Federal Reserve or the $100+ trillion bond market with thousands of domestic and international investors?

The Federal Reserve Is Constantly Behind The Curve

The market usually knows best. The Federal Reserve has consistently made policy errors in the past. For example, it has raised rates when it shouldn’t have. It has conducted a surprise cut when it shouldn’t have. It has also kept rates too low for too long or kept rates too high for too long. This is surprising given how huge the Federal Reserve Bank is and its annual payroll.

Federal Reserve Bank size and huge payroll

The Federal Reserve is trying its best to forecast the future. However, consistently forecasting the future is hard. Therefore, you might as well follow the real-time bond market to see what it’s telling us.

It is the Treasury bond market that gives us a better glimpse of the future. For example, when the yield curve inverts, history shows that there’s a high likelihood of a recession within 18 months of inversion.

The bond market had been screaming at the Fed to aggressively cut the FFR for a year before it finally did. Thankfully, the bond market also gave equity investors who had been paying attention, ample time to reduce equity exposure.

Foreign Buyers Of U.S. Debt

Given the United States is considered the most sovereign country in the world, our assets are also considered the most stable. As a result, China, India, Japan, Europe are all huge buyers of US government Treasury bonds. As a result, their financial destinies are tightly intertwined with ours.

Let’s say China and Japan go through hard landing scenarios. International investors will sell Chinese and Japanese assets/currency, and buy U.S. Treasury bonds for safety. If this happens, Treasury bond values go up, while bond yields go down.

Foreign Holders of US Treasury Bonds
Foreign Holders of US Debt

The U.S. has foreigners hooked on our debt because U.S. consumers are hooked on purchasing international goods, most notably from China. The more the U.S. buys from China, the more U.S. dollars China needs to recycle back into U.S. Treasury bonds.

From a capital account perspective, China certainly doesn’t want interest rates to rise too much in the US. If they do, their massive Treasury bond position will take a hit. As a result, US consumers will spend less on Chinese products at the margin.

Thank goodness we’re all in this together. I expect to see foreign buyers buy up U.S. property in the coming years.

You Want The Federal Reserve On Your Side

Although the Federal Reserve doesn’t control mortgage rates, as real estate and stock investors, you absolutely want the Federal Reserve to be on your side. Once you understand the psychology of rich central bankers, you’ll be able to better protect your finances and benefit as well.

As an investor, an accommodating Federal Reserve is huge. Just look how the Fed helped investors during the entire global pandemic.

The Federal Reserve can be on our side by publicly stating it is carefully observing how various events may negatively affect the economy. The Federal Reserve can also be on our side by not letting the spread between the 10-year Treasury yield and the FFR rate grow too large.

A tone-deaf Fed gives investors zero confidence. At the same time, investors want a Federal Reserve that shows strength and leadership during times of chaos. Always being reactionary instead of being proactive is an ineffective Federal Reserve.

Stay Ahead Of The Federal Reserve

If you want to refinance your mortgage, follow the Treasury bond market. If you follow the Fed, you’ll likely always be one step behind.

The Fed announced it would hike the Fed Funds rate three times in 2022 and three times in 2023. But the 10-year bond yield didn’t go up after the last 2021 announcement.

In other words, the bond market believed the Federal Reserve would be making a mistake if it raises that many times in this two-year window. And usually, the bond market is right.

There is no clearer example of the Federal Reserve not controlling mortgage interest rates than when mortgage rates went down AFTER the Federal Reserve said it would be hiking the Fed Funds rate in December 2021.

Fast forward to 1Q2023, and the Fed is indeed still raising rates. It’s no surprise that the number of 2023 S&P 500 predictions keep increasing that there will be a recession by year end.

It certainly gives us a lot to think about. If you haven’t already, check if your finances an withstand more rate hikes. And, here are some tips on how to enjoy your life after the Fed ruins the world.

Be At Least Neutral Real Estate

Now that you know the Federal Reserve does not control mortgage rates, what now? I recommend everybody be at least neutral the property market by owning your primary residence. Being neutral the property market means you are no longer a victim of inflation given your costs are mostly fixed.

You can’t really profit from the real estate market, unless you sell your house and downsize. You don’t really lose either, so long as you can afford the house, since you’ve got to live somewhere.

The only way you can gain confidence of owning your property for 10 or more years is if:

  • Positive about your career company’s growth prospects
  • Bullish about your own career growth and talents
  • Got 30% or more of the value of your property saved up in cash or liquid securities (e.g. 20% down, 10% buffer at least)
  • You love the area and can see yourself living there forever
  • You’ve got rich parents, relatives, or a trust fund to bail you out

What’s Going On With Mortgage Rates Today?

Mortgage rates are trending higher. Inflation came in at above 9% in mid-2022. As a result, treasury bonds sold off and the 10-year bond yield reached a high of 3.48%. However, inflation is set to moderate. January 2023 inflation figures came in around 6% and the 10-year bond yield is just under 4% as of early March 2023 (went up to 4.23% in October 2022).

Rising rates, increased inventory, and a strengthening US dollar are all deflationary. If the stock market and housing market continues to decline, then even more so by the end of 2023, inflation and interest rates will likely drop back down to trend.

Check online for the latest mortgage rates for free. The more competitive quotes you can get, the better so you can ensure you’re getting the lowest mortgage rate possible.

Invest In Real Estate To Build More Wealth

Real estate is my favorite way to achieving financial freedom because it is a tangible asset that is less volatile, provides utility, and generates income. By the time I was 30, I had bought two properties in San Francisco and one property in Lake Tahoe. These properties now generate a significant amount of mostly passive income.

In 2016, I started diversifying into heartland real estate to take advantage of lower valuations and higher cap rates. I did so by investing $810,000 with real estate crowdfunding platforms. With interest rates down, the value of cash flow is up. Further, the pandemic has made working from home more common.

Take a look at my two favorite real estate crowdfunding platforms.

Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing. For most people, investing in a diversified eREIT is the way to go. 

CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations and higher rental yields. They also have great potentially higher growth due to job growth and demographic trends. If you have a lot more capital, you can build you own diversified real estate portfolio. 

private real estate investment dashboard

With inflation so high, it makes sense to invest in real estate to capture rising rents and rising property values. I’ve invested $810,000 in real estate crowdfunding so far to diversify my SF real estate holdings. I plan to invest another $1 million in real estate crowdfunding over the next three years.

For more nuanced personal finance content, join 55,000+ others and sign up for the free Financial Samurai newsletter. Financial Samurai is one of the largest independently-owned personal finance sites that started in 2009. 

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