When the Federal Reserve (Fed) cuts interest rates, many people expect mortgage rates to fall as well. However, mortgage rates don’t directly correlate with Fed rate changes. This misconception stems from a misunderstanding of how mortgage rates are determined. Here’s why mortgage rates don’t always follow the Fed’s lead and how they’re actually set.
How Mortgage Rates are Determined
Mortgage rates are largely influenced by the bond market, particularly by demand for mortgage-backed securities (MBS). MBS are investment products made up of a pool of mortgages, which are sold to investors. When investors purchase MBS, they effectively fund mortgages, which helps keep mortgage rates stable or even lowers them. When demand for these securities is high, mortgage rates tend to decrease. Conversely, when demand is low, mortgage rates can rise to attract investors back to the market.
The Fed Rate vs. Mortgage-Backed Securities
The Federal Reserve controls the federal funds rate, which is the interest rate at which banks lend to each other overnight. This rate can affect consumer loans like credit cards and auto loans, but it has a minimal direct impact on long-term mortgage rates. Mortgage rates are instead tied more closely to long-term bond yields, particularly the yield on the 10-year U.S. Treasury bond, which investors often use as a benchmark for MBS pricing.
When the Fed cuts rates, it signals economic stimulus, which can have indirect effects on mortgage rates. For instance, if the Fed cuts rates to stimulate the economy, investors may seek safer, long-term investments like Treasuries and MBS, which could lower mortgage rates. However, the effect is indirect, and mortgage rates don’t always move in lockstep with Fed actions.
The Disconnect Between Fed Rates and Mortgage Rates
One of the primary reasons for the disconnect is that the factors driving Fed rate changes—typically short-term economic issues—are different from the factors that influence long-term mortgage rates, like inflation expectations and economic growth. If the market expects inflation to rise, mortgage rates can go up even if the Fed is cutting rates because inflation erodes the value of fixed-rate investments like MBS.
Conclusion
In summary, mortgage rates are set by the bond market and demand for mortgage-backed securities, not by the Fed’s rate cuts. While Fed policy can indirectly influence mortgage rates, other market factors, such as inflation and investor demand for long-term securities, play a much more significant role. This explains why mortgage rates don’t always fall when the Fed cuts rates, making it essential for borrowers to understand that mortgage rates follow their own path, shaped by the broader economy and market demand.