Thursday, January 31, 2008

Why do mortgage rates go up when the Fed lowers rates?

The Fed cut rates 50bp on Wednesday which takes the Fed Funds Rate down to 3.0%. This is a big help for business loans, consumer loans, Home Equity Lines of Credit and Adjustable Rate Mortgages. But how will this affect mortgage rates? As we have said for years, Fed Rate cuts do not have a direct impact on fixed mortgage rates. In fact, they often serve to push them in the opposite direction, by fanning fears of inflation when they cut - or by fighting inflation when they hike. Fixed mortgage rates are directly affected by inflation, because a fixed rate mortgage provides the investor with a fixed rate of return for a long period of time. As inflation increases, the buying power of that fixed return is eroded, because it costs more dollars to buy the same amount of goods and services. So if inflation is on the rise - investors will demand a higher fixed rate of return to compensate them for the more rapid erosion of buying power on their return. The last time the Fed had a long cutting cycle was back in 2001. The Fed cut eleven times in eleven months, and eight of those cuts were by 50bp, for a total of a 4.75% drop in the Fed Funds Rate. But mortgage rates were actually higher throughout this drastic cutting cycle, because inflation ticked higher. Let's look at more recent history, and as we have pointed to previously: the Fed cut by 50bp on September 18, 2007, and after prices enjoyed a move higher that afternoon, Mortgage Bonds lost 94bp over the next two days. On October 31st, the Fed lowered by 25bp...and over the next five trading days, Mortgage Bonds lost 78bp. On December 11th, the Fed lowered by another 25bp, and over the next two days, Mortgage Bonds lost 64bp. Most recently - the surprise 75bp cut by the Fed cost us about 150bp on our rate sheets over the next two days.

Reprinted from an original posting by Michael Lee of Trident Mortgage Bankers (owned by Pudential Fox and Roach Realtors)

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