The Federal Reserve announced this week that it will raise rates for the first time since 2006. What does this mean for real estate investors, mortgages and the U.S. economy in general?
First, a common misconception is that the interest rates set by the Federal Reserve are associated with mortgage rates. They are not the same thing.
When the Federal Reserve sets interest rates, they are referring to the federal funds rate – the interest rate used when banks and credit unions lend reserve funds to each other overnight.
Simply put, banks with surplus deposits in their accounts lend to institutions who need reserves. Financial institutions are required by law to maintain certain levels of reserves, typically 10% of what the bank has lent. This overnight lending is commonplace so that banks can meet their reserve requirements.
Typically, the Federal Reserve raises the federal fund rate when the economy is booming, in an effort to slow it down and fight inflation. It lowers interest rates when an economy is sluggish and in need of stimulus.
The reason yesterday’s rate hike was such a big deal is that it’s been a decade since the fed fund rate has been at near zero levels. This has sent a message to the world that perhaps the U.S. economy is not as vibrant as our government would like others to think.
The Federal Reserve was not going to raise rates until inflation reached 2% and job growth improved. However, they decided to raise rates anyway when job growth was actually down from last year, and inflation did not meet its 2% target.
Normally rates would never increase when the economy is fighting recession like it is today. Manufacturing is already in recession. Commodities are down. Retail sales have been disappointing.
Job growth is below last year’s pace and U6 numbers (the under-employed) are closer to 10%. Last month we had the largest surge of involuntary part-time workers – 300,000 people who want full-time employment couldn’t find it. Labor Force Participation is at 40 year lows. 46 million Americans are on foodstamps – 11 million more than in 2009.
So why did the Fed raise rates during a sluggish economy?
It sent a message.
Janet Yellen, Chairman of the Federal Reserve, suggested all year that rates would increase, but at each meeting she found excuses to not do it. If the Fed didn’t raise rates in December after all the hype, the world’s financial markets would become very suspicious that the US economy was heading into recession, which could actually cause a recession.
But raising rates could do the same thing. The economy is already slow, and a rate hike could slow it further.
The Fed had a very tough decision to make. They were damned if they did and damned if they didn’t. They decided that raising rates was the better choice.
At least if the economy slows further, they can blame it on the interest rate hike. But since they only raised rates by a meager .25%, it’s really only a symbolic gesture and may not have an effect either way. But it does help the Fed save face.
How will this 0.25% Interest Rate Hike Affect Mortgage Rates?
If you have a 30-year fixed rate mortgage, it won’t affect you at all! That’s the beauty of a 30-year fixed rate mortgage: you are locked in at your rate for 3 decades! This is the best loan available if you plan to hold your home for the long-term.
If you are planning to purchase property or refinance your current loan, I’m sure you’re wondering if rates on 30-year fixed mortgages will increase.
While there are many factors that affect mortgage interest rates, the 10-year Treasury bond yield is commonly accepted as the best indicator – more so than the Fed Fund Rate.
The average 30-year fixed rate mortgage is paid off or refinanced within 10 years. Those loans are bundled and sold as Mortgage Backed Securities (MBS). Investors with an appetite for Mortgage Backed Securities also like 10-year U.S. Treasury Bonds.
When the economy is in crisis, these investors tend to choose Treasuries because they are backed by the “full faith and credit” of the United States. When the economy is strong, these investors tend to turn to the stock market for higher returns.
When investors are seeking safety in bonds, bond purchases increase driving bond prices up. As prices increase, the yield decreases. Mortgage rates tend to follow bond yields, so if the economy is sluggish, bond yields decrease and so do mortgage rates.
When the economy improves and investors seek higher yields in the stock market, fewer people buy bonds, so bond prices decrease. As prices decrease, bond yields increase and mortgage rates tend to increase as well.
That’s why you can look at the 10-year Treasury bond yield to help determine which direction mortgage rates are headed. You can find this information on finance sites with a simple google search.
Typically you’d use a spread of 170 basis points (or 1.70% above the current 10-year bond yield) to get an idea of where 30-year fixed mortgage rates will be. Of course, this spread will vary and is only a quick way to guesstimate mortgage interest rates.
After the Fed’s rate hike on Wednesday, the 10-year note yield was trading at 2.31%, up from 2.29%. Adding the 170 basis points would bring 30 year fixed rates to approximately 4.01%.
However, borrowers with adjustable rate mortgages may see their rates go up when the Fed raises rates. If you have an adjustable rate mortgage and have decided to hold your property for longer than a few more years, it may be a good time to refinance into fixed rate loan. Only about 5% of today’s borrowers have adjustable rate mortgages.
Economic activity impacts U.S. Treasuries and Mortgage Rates
As I mentioned earlier, US Treasuries are sensitive to economic activity, which means mortgage rates are as well.
Unemployment numbers, jobs reports, consumer price index, gross domestic product, home sales, global pressures and other economic data can affect bond purchases.
You can expect lower mortgage rates with bad economic news and higher interest rates with good economic news.
That’s why this week’s Fed Fund Rate increase probably won’t increase mortgage rates that much since economic data hasn’t been very positive. And if the Fed rate increase further slows the economy, rates could actually decline further.
We are facing turbulent times and the Fed is running out of ideas on how to turn things around. After $4 trillion in quantitative easing stimulated the economy enough to create bubbles in the stock market and real estate, but not the economy in general, the Fed is more likely to issue a Q4 than raise interest rates again in the near future.
There’s never been a more important time to stay alert. When the stock market and real estate bubbles burst, and they will, you need to be prepared. If you made the right decisions today, you could profit handsomely. If you don’t pay attention and have your nest egg tied to Wall Street or the inflated San Francisco Bay Area real estate, you could lose everything.