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| Why the Fed Rate Cut Pushed Mortgage Rates Higher |
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by Gregory M. Rose, Originator Times
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At 2:15 eastern today, the Federal Reserve Open Market Committee announced that they have cut the discount rate by 25 bps. The Bond market reacted by sending interest rates higher.
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“Historically after a cut in the discount rate, Bonds tend to initially react well and then turn within a few days. There have been other specific instances when the FED cut the discount rate, and it pushed mortgage rates higher immediately, and today is no exception - the rates seemed to spike from the moment of the announcement” said Scott Messina, president of Banking Exchange Technologies, provider of the Bond Rate Monitor. “This is an indication the Fed believes the economy is improving and they only needed to cut rates by 25 bps, which is bad news for bonds and mortgage rates. Unfortunately,
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most loan originators do not understand the relationship between the discount rate and mortgage rates. What they need to understand is that it’s not about what the FED does to the rate that really counts, it’s about bond traders asking themselves does this mean the economy is getting better?”
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A cut by the FED has no direct relationship to the bond market, but it does affect it, and to understand this, one must truly understand why and how people invest in bonds.
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All bonds are sold at a discount. When the Federal National Mortgage Association (FNMA) issues a $100,000 bond, they sell the same bond for a discount, say $97,000. In 30 years, when the purchaser presents this bond for payment, FNMA gives the purchaser $100,000, and the purchaser has earned $3,000 in interest over a thirty-year period.
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So a bond investor’s worst nightmare is inflation. When inflation begins, the price of bonds move down, causing a higher interest rate. Why? Because a bond investor is investing today’s dollars for a pay out thirty years in the future. In an inflationary period, these investors would only be willing to pay, say $94,000 for that $100,000 bond, since the money will be worth less in thirty years.
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And what does all this have to do with the FED? The FED uses the overnight rate to stimulate or stymie the economy. It really doesn't matter to bond investors if the FED cuts or raises rates. Bond investors only care about inflation. “Today’s spike was really quite predictable when you consider all the talk that was going around about a potential 50 bps cut,” said Messina. “Basically you have the FED coming out today and saying, hey the economy is getting better, so we don’t need to cut rates by 50 bps, half that will do it.”
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Loan originators should pay attention to how the economy is doing and the FED’s reaction to the economic news. If the FED reacts as if the economy is getting worse interest rates will fall, but if they indicate things are improving rates are sure to go up.
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Why? Because perception is reality.
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