Why the Fed Cut may not improve mortgage rates

Jul 31, 2019 11:07:09 AM

Don't shoot the messenger

One of the most widely misunderstood dynamics of my business is the belief that a Fed rate cut immediately lowers mortgage rates. Well, I hate to break it to you, but the Fed doesn't touch mortgage rates; however they make monetary policy changes that shake our world and yes... interest rates. So allow me to support my "click-bait" headline with some comments and fact.

The main fact is that the Fed doesn't directly touch mortgage rates. The Fed sets a target for the "fed funds rate" after reviewing mountains of current economic data. The rate that they tweak is the interest rate banks charge each other for overnight loans. Those loans are called fed funds, which lowers the as the Fed lowers interest rates. This change, albeit small or great, has great impact on the markets. But the way it moves mortgage rates is quite the conundrum. I'll explain...

Why does the Fed even cut rates?

When the economy is slowing, the Fed cuts the aforementioned federal funds rate to stimulate financial activity. A decrease in interest rates by the Fed has the opposite effect of a rate hike which is designed to curb inflation and slow the economy.

A Fed cut may not improve mortgage rates

As I eluded to early, there is much confusion on this topic. If the Fed cuts rates, shouldn't mortgage rates go down? I've heard it before, "I heard the Fed is going to cut rates this week, so I'm going to wait (to buy or refinance)". Although this sounds completely logical, it's the wrong conclusion. You see, the markets have already priced in future cuts and mortgage rates therefore improve well in advance of the impending rate cut(s).

Ever been to an Apple Store the day of the new iPhone release? What do you see? A HUGE LINE. People knew that the iPhone was going on sale and they got in line. Mortgage markets operate the same way. Traders knew that a "Fed Interest Rate Sale" is going to happen, so they got in line, bought before the release, and because of this activity drove the price of mortgage bonds up and yields down. Result: Mortgage rates go down.

Terrible analogy, but to reiterate, we've been seeing the positive impact of these "impending rate cuts" for months now. Those that are still waiting to lock in that "low rate" is like the guy that gets to the Apple store at noon on release day. You're too late.

From the media

ABC News had an economist on who laid it out plain as day. Regarding the pending rate cut... "It'll be a small cut, it's anticipated, so it's already factored into longer-term interest rates like mortgage rates and auto loans," Michael Feroli, chief U.S. economist at JPMorgan, told ABC News. "The change is already reflected. There may be a small change in things like a money market fund or CD deposits."

My Two Cents and Recommendation

Since the markets have already priced in the rate cut of today (and future rate cuts), mortgage rates have been improving steadily for months. If anything, rates actually get worse (short term) after a rate cut. This seems counter-intuitive, but a rate cut is meant to spark the economy which (in it's purest form) creates inflationary pressures. Inflation is the arch-enemy of bonds and mortgage rates; therefore we could easily see higher mortgage rates immediately after a Fed cut.

My advice is to well time the locking in your loan BEFORE a fed cut. The further one waits as cuts begin and continue to happen, the more the propensity for rates to go back up.

You aren't too late

Mortgage rates have already started to trickle back up, but it's not too late. Most everyone that bought a home late last year should refinance. Anyone that's at 4% or higher should look at refinancing (especially those with a VA loan).

So please... if you want the new iPhone, even if you are tad late, get in line.