News of the Federal Reserve raising “interest rates” to combat inflation has been a big topic in the news lately but which rate is the Fed actually raising? Are they raising mortgage rates directly? No, but mortgage rates have definitely increased in the past year and it seems the two are correlated, however, the relationship between the rates the Fed controls and mortgage rates is confusing at best. At the risk of gross oversimplification here’s my understanding of how mortgage rates are influenced by monetary policy.
Federal Reserve Rates
There are two rates that the Federal Reserve actually sets or has control over. The first is called the Discount Rate. This is the rate at which banks can borrow money from the federal government overnight to recapitalize and maintain their required minimum deposit levels.
The second is the Fed Funds Rate which is the rate banks charge when lending money from one bank to another
Both of these rates in turn effect the rates at which those banks lend money to corporations and individuals so that they maintain a profit on those loans i.e. they lend it for more than they borrowed it for.
The Fed uses these two rates to try to control inflation. As the theory goes, the more expensive it is to borrow money, the higher the cost of goods, services, capital expansion, etc.. Eventually this causes the economy slow and with it, inflation. Whether this is the correct cause-effect relationship in our current economy is a debate for another time.
Back to our theory. As the cost of goods and services increases, consumers buy less and companies become less profitable (again, this is theoretical). Ultimately this leads to lower returns for anyone who has invested in that company.
Let’s pretend you are managing an investment portfolio and what you’ve invested in is losing value. You’re going to look for better, safer alternatives for where to put your money and generally that means moving it from riskier, short-term investments to longer-term, lower yield (a.k.a. lower return) but more secure, investments. Enter one of the most common and most secure long-term investments, the 10 year government bond.
10 Year Bonds:
10 year bonds are considered a safe haven for investors because the return at the end of the 10 years is guaranteed by the government.
The inner workings of bond pricing and yields is a black-hole in-and-of-itself but for the sake of our 10,000 foot view, the important piece to understand is that these bonds cost more, and produce greater returns for investors, as inflation rises and the long-term health of the economy (see also – the stock market) becomes more volatile.
However, 10 year bonds are only one of many longer-term securities that investors can use to balance the risk in a portfolio. Enter player two in our story, the mortgage backed security.
Mortgage Backed Securities
When banks originate a mortgage, they typically sell off the note (the buyer’s promise to reply the loan) on the secondary market. This allows them to recapitalize the money they loaned so that they can then loan it to someone else.
These resold mortgages are bundled together and “securitized” meaning they’re converted to something that can be traded like a stock or bond on an exchange. These bundles are called mortgage backed securities. The yield (or return) of these securities is largely determined by the interest rates of the mortgages within the bundle.
Mortgage backed securities are considered a similarly safe investment as 10 year bonds since most mortgages are backed by the government either directly, such as FHA insured or VA guaranteed loans, or they are purchased from the originating bank by one of the three government managed institutions, created for exactly this purpose and commonly known as Fannie Mae, Feddie Mac, and Ginnie Mae. These three organizations have specific requirements for the types of loans and the qualifications of the people the loans were made to so investors tend to see them as consistent and predictable securities. Even more so following the financial crisis of 2009 when underwriting guidelines were made much more stringent leading to far less risk of buyers defaulting on their mortgages.
Putting It All Together
Since most homeowners keep their mortgage for an average of 7-10 years, and default rates are now extremely low, mortgage backed securities compete directly with 10 year bonds in the investment market as long-term, “safe” investments.
And because they compete, when Fed rates rise to combat inflation and cause 10 year bond yields to rise – mortgage backed securities must also increase their yield rates in order to stay competitive and continue to attract investors. If they don’t, banks can no longer sell off the notes for the loans they make and they will eventually run of money to lend.
We said earlier that the yields of mortgage backed securities are closely tied to the interest rates of the mortgages that have been bundled together to make the security so in order to increase the yield, the rates of the mortgages that are being bundled together must increase.
Clear as Mud
Just when we thought it made sense, you’ve likely heard that mortgage rates have been dropping even though the Fed continues to raise the discount rate in small increments and have signaled that they are going to be less aggressive going forward. In fact, many economist now believe that we’ll likely avoid a full-blown recession and the longer term outlook on the health of the economy is improving. But if the economy is once again starting to head in the right direction, why is the Fed still raising rates?
I agree, it’s confusing. And confusing can be off-putting so maybe this will help. Our economy has essentially been partying hard for quite some time; so much so that it has run itself ragged, weakened its immune system, and contracted an infection we’ll call “inflation-itis”. Raising the Fed rates is like taking antibiotics to fight off this nasty infection. The resulting increase in mortgage rates we’ve seen is less of a symptom of the inflation-illness itself but instead, more akin to a side effect of the medicine (kind of like getting drowsy when you take an antihistamine or read a blog post about interest rates…). Eventually we’ll start feeling better before we’re done taking the antibiotics – i.e. mortgage rates will drop before the Fed stops raising their rates – which they’ll continue to do for a bit because, as we know, we must finish the z-pack or the infection will rear its ugly head again.
Here’s to hoping we can all stay well physically, mentally, and fiscally going forward!