Aug262015

Fed rate hike may lower mortgage rates

If increasing the federal funds rate causes inflation expectations to drop, mortgage rates may actually fall, causing further rises in home prices.

Mortgage interest rates are the single-most important factor determining the borrowing power of a potential house buyer. When rates are very low, a borrower can service a large amount of debt with a relatively small payment, and when interest rates are very high, a borrower can service a small amount of debt with a relatively large payment.fed_taper_stimulus

Mortgage interest rates are determined by market forces where investors in mortgages and mortgage-backed securities bid for these assets. The rate of return demanded by these investors determines the interest rate the originating lender will have to charge in order to sell the loan in the secondary market. Some lenders still hold mortgages in their own investment portfolio, but these mortgages and mortgage rates are subject to the same supply and demand pressures generated by the secondary mortgage market.

Mortgage interest rates are determined by investor demands for risk adjusted return on their investment. The return investors demand is determined by three primary factors:

  • riskless rate of return,
  • inflation premium and
  • risk premium.

The riskless rate of return is the return an investor could obtain in an investment like a short-term Treasury Bill. Treasury Bills range in duration from a few days to as long as 26 weeks. Due to their short duration, Treasury Bills contain little if any allowance for inflation. A close approximation to this rate is the Federal Funds Rate controlled by the Federal Reserve. It is one of the reasons the activities of the Federal Reserve are watched so closely by investors.

Components of Mortgage Interest Rates

The closest risk-free approximation to mortgage loans is the 10-year Treasury Note. Treasury Notes earn a fixed rate of interest every six months until maturity issued in terms of 2, 5, and 10 years. The 10-year Treasury Note is a close approximation to mortgage loans because most fixed-rate mortgages are paid off before the 30 year maturity with 7 years being a typical payoff timeframe.

The difference in yield between a 10-year Treasury Note and a 30-day Treasury Bill is a measure of investor expectation of inflation, and the difference between the yield on a 10-year Treasury Note and the prevailing market mortgage interest rate is a measure of the risk premium.federal_reserve_printing_money

Inflation reduces the buying power of money over time, and if investors must wait a long period of time to be repaid, as is the case in a home mortgage, they will be receiving dollars that have less value than the ones they provided when the loan was originated. Investors demand compensation to offset the corrosive effect of inflation. This is the inflation premium.

The risk premium is the added interest investors demand to compensate them for the possibility the investment may not perform as planned. Investors know exactly how much they will get if they invest in Treasury Notes, but they do not know exactly what they will get back if they invest in residential home mortgages or the investment vehicles created from them. This uncertainty of return causes them to ask for a rate higher than that of Treasury Notes. This additional compensation is the risk premium.

Mortgage interest rates are a combination of the riskless rate of return, the risk premium and the inflation premium.

With that background, it’s easier to understand the scenario by which the federal reserve could raise the federal funds rate and actually cause mortgage rates to fall. If you refer back to my conceptual diagram, the bottom component of mortgage rates is the base rate. This is what the federal reserve is about to increase by 0.25%. The second component is the inflation expectation, and the federal reserve’s actions could cause this to decline by more than 0.25%.

If inflation expectations decline more than the base rate goes up, mortgage rates may fall.

The Fed hike could LOWER interest rates

Kelly Evans, Monday, 24 Aug 2015

The public has been seemingly desperate for the Federal Reserve to raise interest rates.

“Savers are getting creamed here,” has been a common refrain.

federal_reserve_steals_from_retirees

“Banks are getting crushed.”

If that were the case, I would be all for it…

https://www.youtube.com/watch?v=6PQ6335puOc

“Crush the banks, see them driven into oblivion, hear the lamentation of their investors.”

“Zero percent sends a bad message, it undermines confidence.”

Even the experts seem upset by the inertia: “It’s simply time,” has become another popular phrase.

Any “expert” that mutters that phrase is a fool.deflation psychology

Imagine what would happen, then, if the Fed raised rates—and they dropped even lower, instead. That’s effectively what’s happening today.

I was inspired by this article because I hadn’t seriously considered this possibility. Prior to watching long-term yields go negative in Europe recently, I never considered that possible either, so I thought it was a good to to reexamine my feelings on mortgage rates.

The negative yields in Europe demonstrate that even very low inflation expectations can move lower. In effect, Europe had a negative inflation expectation (a positive deflation expectation) that made all their rates lower. So while our mortgage rates look very low, it’s not unreasonable or unprecedented that they might go even lower.

Will lenders start paying us to borrow money?

Even if the Fed hasn’t raised interest rates, it has stopped lowering them, and it has stopped the balance-sheet expansion that replaced rate cuts once its target rate hit zero.

That, combined with a stronger U.S. dollar, means despite rates still being near zero, the Fed has effectively been tightening monetary policy.

Let’s be clear: the federal reserve did not effectively tighten monetary policy. The market did that.yellen_raise_rates

And yet, longer-term interest rates are dropping. The yield on the 10-year U.S. Treasury note was nearly 2.3 percent at the beginning of August; it just dropped back below 2 percent amid the global stock-market rout.

That is in sharp contrast to widely held expectations for rates to rise this year—a call that has been repeated, and repeatedly wrong, for many years now, even as the Fed has signaled it is about to hike rates for the first time in over a decade.

For the last several years, most investors and analysts believed rates would rise, and each year, they were wrong. The forces of debt deflation overwhelmed the efforts to generate inflation and stimulate more spending, so inflation expectation is low and rates remain low because of it.

Remember that all the Fed does is set a targeted extremely short-term, overnight interest rate that most impacts banks and other financial players that deal directly with the central bank.

What happens to longer-term interest rates, like the benchmark 10-year Treasury note that sets most mortgage rates, is a different story.

Which is why we had Operation Twist to buy 10-year Treasuries and mortgage notes.Yellen_fed_reflation

Sometimes, all interest rates are moving higher at the same time. That’s because the market thinks inflation will be higher over a longer time horizon, and so demands a higher yield on longer-term securities.

Today though, the market isn’t so convinced that inflation will be higher over time.

“More than half the components of the consumer price index have declined in the past six months,” observed former Treasury Secretary Lawrence Summers, who just warned that if the Fed raises rates at its next meeting, in September, it will be making a “historic mistake.”

I also think it would be a mistake, and I also don’t believe the federal reserve will make that mistake (See: Why the federal reserve will not raise rates in 2015)

The collapse in oil and other commodity prices has added renewed downward momentum to the global inflation cycle. China, the biggest driver of global growth the past decade, is notably slowing and already experiencing deflation on the wholesale-price level. Big markets across the Middle East, Asia, and Latin America are in turn slowing too.

The problem with inflation expectations is not caused by any of the issues listed above. The world economic system is still loaded with bad debt from the 00s, and the expectation that this debt will be wiped away in bouts of deflation is what’s causing inflation expectations to be so low.

Market-based measures of inflation expectations in the U.S. continue dropping, now pricing in less than 2 percent annual inflation several years out. That indicates “a serious and sustained undershoot of the inflation target,” said Michael Darda, chief economist and market strategist at MKM Partners, in a recent note to clients.

consistencyIf you hold cash, a serious and sustained undershoot of the inflation target is a great thing. If you are a debtor struggling with a mountain of bubble-era debt, no so much.

That in turn is pulling down the yield on longer-term interest rates.

The more the Fed tightens policy against this backdrop, with slowing global growth, falling inflation, and a flight to the U.S. dollar, the more those long-term inflation expectations could drop, dragging yields down with them.

Declining inflation expectations, or more accurately put, increasing deflation expectations are weighing on yields and rates.

Former Fed Chair Alan Greenspan once called this effect, when longer term yields were falling even as the Fed was steadily raising short-term rates back in 2005-06, a “conundrum.”

Greenspan_housing_bubble_foreclosure

Today, he says he thinks this behavior, also being witnessed today, is rather logical—and that the “conundrum” may actually be prior periods when higher short-term rates begat higher long-term rates as well.

What’s all this mean for those desperate for higher rates?

That paradoxically, the best way to get them is likely for the Fed to not hike at the moment.

“If the Fed remains on the current course,” said Darda, the risk of a “premature” rate hike, and hence a return back to zero during the next downturn, “will likely rise significantly.”

The zero bound used to be a bogeyman, but after several periods of QE, I don’t think the federal reserve is nearly as worried about this problem anymore. They certainly don’t want to fight deflation, as they consider deflation much worse than inflation, but the federal reserve believes they have a new tool with QE, and I wouldn’t be surprised to see them use it if we have another downturn too soon.

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