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By G. Steven Bray
Over the weekend, the Federal Reserve cut the federal funds rate to zero, and it seems the whole world is asking today, “Where can I get that free money?” And, unfortunately, you can’t. The reasons are a little complex, but let’s see if we can break it down a little.
First, you have to realize that the federal funds rate, and in fact all the rates the Fed directly sets, are very short-term rates. Mortgage rates are long-term rates. They respond to different factors, and often move higher when the Fed rates are moving lower.
So, mortgage rates have been on a wild ride the last couple weeks with rates falling to record lows, then bouncing 25% higher in just one week. The reason they fell so quickly is the same as the reason the Fed acted this weekend: the pandemic is slowing our economy. But it looks like the virus is going to be with us for a while, so why didn’t rates remain at record lows? Let’s analyze the causes and predict what will happen over the coming weeks.
Mortgage rates are a reflection of the price investors are willing to pay for mortgage-backed securities – basically, your mortgage bundled with a bunch of others as an investment. That price is influenced by a number of factors. We discuss some of those factors regularly, such as expectations for economic growth and expectations of inflation. It’s economic growth expectations that caused rates to plummet a couple weeks ago.
But we had other negative factors come into play last week.
- – One of those factors we call runoff. As we’ve discussed before, investors buy mortgage bonds expecting to earn interest over a number of years. When mortgages pay off early, such as through refinance, investors actually may lose money. In response, investors lower the price they’re willing to pay for mortgage securities, which results in higher rates.
- – A second factor is basic economics: supply and demand. The drop in rates generated an enormous number of mortgage applications. We didn’t have enough investors to absorb all that supply. On top of that, investors didn’t seem to be the mood to buy much of anything last week as prices dropped in most markets.
- – Finally, lenders’ systems were overwhelmed with the volume of new applications, and many of them raised their rates as a means of throttling that volume.
So, what’s next? While the federal funds rate announcement isn’t going to lead to lower rates, one of the Fed’s other actions may. The Fed is stepping into the market to buy a small amount of mortgage-backed securities. It appears this is returning liquidity to the market as rates have dropped a little today.
It probably will take a few weeks to dissipate the other negative factors, but I suspect the positive factors, slowing economy and negligible inflation, will still be in place. And once that happens, we could see record low mortgage rates again.