Fed rate cuts and mortgage rates

So the Federal Reserve cut rates again. Many mortgage applicants are calling their mortgage representative and expecting a lower interest rate. Others who have been waiting to refinance are puzzled as to why mortgage rates have not moved lower during recent 5 Fed rate cuts. In fact mortgage rates are now higher than they were before the Fed began cutting rates by in January. This is difficult to explain to many consumers who have watched a 2.5% reduction by the Fed with no benefit in mortgage rates.

Is a Fed rate cut really good news for mortgage rates? The facts may be surprising. The Fed can only control the Discount Rate and the Fed Funds Rate. This is very different from mortgage rates. A mortgage rate can be in effect for 30-years, a rate that is set by the Fed can change from one day to another.

Another common mistake is in thinking that 30-year Treasury bonds or 10-year Treasury notes are directly pegged to mortgage rates.

Those are government securities that are backed by the full faith and credit of the U.S. government and have no direct effect on mortgage rates.

So what are mortgage rates based on? As it turns out the answer is mortgage-backed bonds known as Mortgage Backed Securities (MBS). Bonds issued by Fannie Mae and Freddie Mac (MBS) and the trading performance of those bonds will determine the direction of mortgage rates. Finding the catalyst that causes mortgage bonds to move will give you the keys to finding out what makes mortgage rates rise or fall.

We know that inflation will always be a negative for any long-term bond because it eats away at the future returns. Since the bond will pay a set amount over a long period of time, that amount will be less valuable if inflation is high. Over the past several years, one catalyst that seems to be working in the opposite direction of MBS prices is the Nasdaq and broader stock market.
As bond prices rise, interest rates fall. As bond prices fall, interest rates rise. The charts accompanying this article show the Nasdaq Composite Index and the Fannie Mae 6.5% mortgage bond tend to follow paths that are almost mirror images of each other. The consistency of this behavior is astounding.

As the Nasdaq moves higher, bond prices move lower causing interest rates to rise. As the Nasdaq declines, mortgage bonds benefit, causing mortgage rates to fall. Additionally, and unlike common opinion, Fed rate cuts have had virtually no direct effect on mortgage rates. Moreover, it appears that since Fed rate cuts act to stimulate the Nasdaq, they have a negative effect on mortgage rates.

The bottom line is that it appears mortgage rates will get better if the Nasdaq sells off and will get worse if the Nasdaq rallies. So it is not necessarily what the Fed does that affects mortgage rates, it's how the Nasdaq and broader stock market interprets the Fed's action that will ultimately influence the direction of mortgage rates. This is because money managers and mutual fund companies typically keep funds in either stocks or bonds with very little in cash. If stocks are in favor, money is pulled from bonds, causing bond prices to drop and interest rates to rise. When stocks are being sold off, the money is then parked into bonds, which improves bond prices and causes interest rates to decline.

On the chart of the Nasdaq Composite Index above, notice how the price movement higher on the Nasdaq seems to correlate to mortgage bond price deterioration (shown below) and vice versa. Once again, lower bond prices translate to higher mortgage rates and higher mortgage bond prices mean lower mortgage rates.

The chart below shows how the Fannie Mae 6.5% mortgage bond has performed during the same time period. The green circles indicate Fed rate cuts and the area circled in red shows when the Fed hiked rates.

A closer look at the 5 rate cuts by the Fed this year (see chart below) shows that mortgage bond prices deteriorated after each Fed rate cut. This means that mortgage rates rose after the Fed had cut rates while many consumers were expecting their mortgage rates to decline. Worse yet are the consumers who missed the opportunity to obtain a lower rate because they mistakenly waited for the anticipated Fed action to cut short-term rates, thinking that longer-term mortgage rates would decline as a result.

Predicting the future is tough, so nothing is written in stone. Keep an eye on the Nasdaq, and keep in mind that the best rates may be behind us. But, mortgage rates are still low and could have some quick dips so make the most of them while they last.

CMG quoted in the NYSun. 2.15.08

Mortgages Get More Costly As Fed Cuts Interest Rates
By JULIE SATOWStaff Reporter of the SunFebruary 15, 2008

Since the Federal Reserve chairman initiated a series of aggressive interest rate cuts last month, it has actually gotten more expensive for buyers to take out mortgages.

The reason is that investors are increasingly fearing inflation and are driving up the yield on the 10-year Treasury, off of which most residential mortgage rates are priced. In fact, the yield on the 10-year note topped 3.8% yesterday, a one-month high; before Chairman Ben Bernanke's surprise 0.75 -percentage-point rate cut in January, the yield was 3.4%.

Bond buyers aren't likely to be reassured anytime soon, with Mr. Bernanke testifying yesterday before the Senate Banking Committee that additional rate cuts are possible. He has already cut the target for the key federal funds rate by 2.25 percentage points since September, chopping off 1.25 percentage points, to 3%, in January alone. The Federal Open Market Committee, which is responsible for cutting rates, is next scheduled to meet March 18.

"The FOMC will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks," Mr. Bernanke said. He also called the economy "sluggish," saying it was unlikely to recover until later this year, and suggested there would be more mortgage-related losses at banks.

The markets responded poorly to Mr. Bernanke's testimony, with the Dow Jones industrial average falling 175.26 points, or 1.4%, to 12,376.98 at yesterday's close. The 10-year Treasury fell for the third straight day, with the yield curve steepening as the 10-year yield reached its highest level compared with the two-year Treasury yield since July 2004.

"The bond market has the ability to see into the future, and the smart money sees inflation out there," a principal at mortgage firm Commodore Mortgage Group, Richard Bouchner, said. He said that when rates were lower, he called all of his clients suggesting they refinance their mortgages. "Most stayed on the sideline because they expected more rate cuts, but now they've missed their opportunity," he said.

Mr. Bernanke's rate cuts haven't just failed to lower mortgage rates — the Fed chairman is also spurring a new credit crunch, analysts say. The leverage loan market is nearly closed, with yields so low that they offer little incentive for lenders, while worries over defaults persist.
"With Mr. Bernanke's reiteration of his current rate-cutting path, the credit market noose continues to tighten," an equity strategist at Miller Tabak + Co., Peter Boockvar, wrote in a research note. He called the tightening of credit in the market "an unintended consequence" of the Fed's rate cuts.

In addition to a lack of leveraged loans, there is a shutdown of so-called auction rate securities. This is a more than $300 billion market where long-term municipal bonds, student loans, and corporate bonds are repackaged to create short-term paper and auctioned off to investors. Investors, however, have stopped bidding for them, and so banks have stopped providing auction support. Investors and banks are balking because the breakdown in bond insurance for these securities, as monoline insurers such as MBIA and Ambac struggle to cover their losses, as well as the low yields, provide little incentive for investors to take on the growing default risk.
An analyst at Banc of America Securities, Jeffrey Rosenberg, wrote in a research note on Wednesday that 80% of these auction rate securities auctions are failing.

"With a total size of $330 billion and roughly half of that held by individuals, a significant, albeit likely short lived liquidity crunch is again emanating out of the credit markets," he wrote.
Not everyone believes Mr. Bernanke's rate cuts are bad for the economy. "The rate cuts are definitely helping," a professor of economics at New York University, Mark Gertler, said. Mr. Gertler attributed rising yields on the 10-year Treasury note to investors predicting the economy will improve and that the Fed will eventually raise rates again. "It's going to be a sluggish period for a couple of quarters, but I have reason to believe we will be in a recovery by the end of the year."

Still, a growing number of investment banks and economists are predicting we are in a recession, and some feel that Mr. Bernanke's rate cuts are not addressing the problems.
"Unfortunately, bankers are no longer in the business of taking deposits and loaning money, but rather in securitizing loans," a professor at the University of Maryland School of Business, Peter Morici, a former chief economist at the International Trade Commission, said. "Mr. Bernanke has simply not addressed this more fundamental structural problem that frustrates his monetary policy. Lowering the fed funds rate does absolutely nothing to help clear up that issue."