Assume that the Fed cuts the discount rate. Will this be a good thing or a bad thing for mortgage interest rates? Lower rates are good across the board, right? Consumers get excited, rush out to buy a house and then call for that lower rate. Right? Maybe, maybe not. You may be surprised at how the mortgage market reacts to a Fed rate cut.
Think about this. More often than not, especially in recent years, immediate reaction to a Fed rate cut resulted in mortgage rates actually increasing instead of declining. Why? Because of supply and demand for investment returns.
What do I mean by this? I mean to say that there is a somewhat limited supply of investable funds and the equity market (stocks) and the debt market (bonds, mortgages, treasuries,etc) compete for those funds. Generally speaking, when the stock market is having a difficult time, investors park their funds in debt and when the stock market looks like a good place to invest, those funds come flowing out of debt and back to stocks.
Over the last several weeks, the stock market has been battered and bruised over the "liquidity" issue facing mortgage makers and their backers. Rampant selling of those stocks with even a limited exposure to the sub-prime mortgage market has resulted in an overall decline in the value of stocks. In essence, many companies were painted with the "sub-prime" brush when they had only limited exposure. Investors sold the stock, took their money and parked in in more secured assets-those being treasuries notes and high quality mortgage backed securities (not sub-prime).
Which brings us back to a potential Fed rate cut. If investors have the perception that the liquidity issue has been addressed, they will sell those bonds and mortgages (even in the face of lower short termrates) and move money back to stocks. With fixed income investments, if you have more sellers than buyers, the value of those investments decline and rates increase. This is what COULD happen relatively soon.
Combine this scenario with inflationary pressures and you may have a very detrimental effect on mortgage rates. This scenario is all based on investors perception about future risks in liquidity.
Again, be careful of a Fed rate cut...you might get your wish!
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