What Happens When the Fed Lowers Rates – Part 3

In the last two articles I have discussed the inter-relationships between short-term rates that the Fed controls, the Discount Rate and the Fed Funds Rate, and long–term rates, including mortgage rates. We dispelled any notion that what the Fed has done recently or might do in the near future has an impact on mortgage rates.   In this final article, we’ll discuss things that affect the bond market and thus affect the course of interest rates in the future.

Bond rates are not a result of a committee meeting but the result of the actions of traders and investors in long-term securities that are bought and sold every day in the fixed-income securities market. In fact, rates took a sharp jump on the day that the Fed lowered rates .25 percent. In the last ten days, the yield on the 10-year bond has risen even further, and is now up about .5 percent from the bottom. Mortgage rates have followed.

So if you are a shopper seeking to buy a home or a homeowner considering a refinance, what should you do? Do you feel as if the train left the station without you. I would like to present some factors that are likely to have an impact on rates so as to help you decide what course of action to take.

Remember that the bond market is not an island. It is influenced by what is happening in other markets, such as the stock market, the commodities market, markets in other countries, and the exchange rate between the dollar and currencies of other trading partners.  

For example, the stock market in Japan suffered extraordinary losses ten years ago and interest rates in Japan have been close to zero for over a decade.   Japanese investors looking for a better return on their investments have been big buyers of U.S. Treasury securities, providing demand that arguable kept our government and economy afloat during the troubling economic times in the late ‘80’s and early ‘90’s. What would U.S. interest rates have been during this period absent these buyers?   Higher, for sure.

Another phenomenon affecting the bond market is called the “flight to safety.” For example, during the collapse of the dot-com companies and severe declines in the stock market, people pulled money out of the stock market and bought bonds because their principal was then safe from further erosion.   This caused the demand for bonds to exceed the supply.   When that imbalance happened, the price of bonds went up, which forced yields down.   Mortgage rates followed suit.

Finally rates have fallen because of the weak economy. The economy has continued to go into the tank, compounded by the aftermath of 9-11.   As with any market, no one knows the exact reasons but you can see that thee combination of a number of factors could have been reasons for the decline in rates over the last few years.  Let’s review factors as they exist currently.

While unemployment is still high, and there are still areas of economic malaise, it does appear that a number of areas that are getting better.   The stock market has risen dramatically in the last month as stock investors seem to think that the prospects are good.   Remember that the stock market generally is responding to what people believe will happen six or nine months in the future, not tomorrow. If this continues, more people are going to pull money out of those “safe haven” bond funds and buy stocks. That means yields will rise.   The bond market also seems to think that we may see a higher rate of inflation in the intermediate term.

Bottom line, if you think that the economy is not going to recover anytime soon, you will feel comfortable with the view that rates will stay down. If you think that a recovery has started, then you will probably feel comfortable with the view that rates will increase.   If that turns out to be the case, as I think is more likely, then we’ll see rates increase, although probably not dramatically as this time, the rate of improvement in the economy looks to be cautious.

So let’s go back to question posed earlier: What’s a borrower to do? I believe that the answers are independent of what is going on instantly. If you are refinancing and the rate is still good enough to justify the transaction, don’t try to outguess the market by hoping that rates will drop.   Lock in your rate now and don’t look back.   If you are in the market for a home, rates are still at terrific levels, maybe up a little bit from the lows that lasted for just a couple of weeks, but they certainly are not up so much as to impair qualifying or affordability. Continue your shopping.

Go for it!