A lender that I work with quite often, Brendan O'Driscoll with Treadstone Mortgage sent me this information. He is allowing me to blog it as this question does come up a lot.
Your customers may ask you about this and most people get it wrong. It's a long read, but informative:
This is Interesting
When the Fed cuts rates, it lowers variable rates and lines of credit, but often has a negative effect on Mortgage rates. The Fed cuts (or raises) the overnight lending rate between banks, who usually follow suit by cutting (or raising) the Prime Rate. The Fed does NOT cut mortgage rates. In the most simple terms, mortgage rates are driven by Treasury Bonds. So when the Stock Market struggles, people move their money to the safe haven of conservative, Treasury Bonds. Which is Good for Interest Rates. When Stocks are strong, the conservative money leaves Treasuries and goes back to the Market which raises interest rates. In short, good news for the stock market and your investments/retirement is bad news for mortgage rates and vice versa.
Why Do Mortgage Rates Change?
When the Federal Reserve "cuts rates", they are typically cutting the Discount rate and the Fed Funds rate. Many misunderstand this "cut" to mean that mortgage rates were cut. Mortgage rates are affected by many factors but are not "cut" by the Fed. There are many types of interest rates.
Prime rate: The rate offered to a bank's best customers.
Treasury bill rates: Treasury bills are short-term debt instruments used by the U.S. Government to finance their debt. Commonly called T-bills they come in denominations of 3 months, 6 months and 1 year. Each treasury bill has a corresponding interest rate (i.e. 3-month T-bill rate, 1-year T-bill rate).
Treasury Notes: Intermediate-term debt instruments used by the U.S. Government to finance their debt. They come in denominations of 2 years, 5 years and 10 years.
Treasury Bonds: Long-debt instruments used by the U.S. Government to finance its debt. Treasury bonds come in 30-year denominations.
Federal Funds Rate: Rates banks charge each other for overnight loans.
Federal Discount Rate: Rate New York Fed charges to member banks.
Libor: London Interbank Offered Rates. Average London Eurodollar rates.
6 month CD rate: The average rate that you get when you invest in a 6-month CD.
11th District Cost of Funds COFI: Rate determined by averaging a composite of other rates.
Fannie Mae-Backed Security rates: Fannie Mae pools large quantities of mortgages, creates securities with them, and sells them as Fannie Mae-backed securities. The rates on these securities influence mortgage rates very strongly.
Ginnie Mae-Backed Security rates: Ginnie Mae pools large quantities of mortgages, secures them and sells them as Ginnie Mae-backed securities. The rates on these securities influence mortgage rates on FHA and VA loans.
Interest-rate movements are based on the simple concept of supply and demand. If the demand for loans increases, so do interest rates. This is because there are more buyers, so sellers can command a better price and higher rates. If the demand for credit (loans) reduces, then so do interest rates. There will be more sellers than buyers, and now buyers command a better price, and lower rates. When the economy is expanding there is a higher demand for credit and rates move higher, whereas, when the economy is slowing the demand for credit decreases and so do interest rates. Generally speaking, bad news of a slowing economy is good news for borrowers and lower rates. Good news of a growing economy is bad news for borrowers and higher rates.
A major factor driving interest rates is inflation. Higher inflation is associated with a growing economy. When the economy grows too strongly, the Federal Reserve increases interest rates to slow the economy down and reduce inflation. Inflation results from prices of goods and services increasing. When the economy is strong, there is more demand for goods and services, so the producers of those goods and services can increase prices. A strong economy therefore results in higher real-estate prices, higher rents on apartments and higher mortgage rates.
Mortgage rates tend to move in the same direction as interest rates. However, actual mortgage rates are also based on supply and demand for mortgages. The supply-and-demand equation for mortgage rates may be different from the supply-and-demand equation for interest rates. This might sometimes result in mortgage rates moving differently from other rates. For example, one lender may be forced to close additional mortgages to meet a commitment they have made. This results in them offering lower rates even though interest rates may have moved up.
There is an inverse relationship between bond prices and bond rates. This can be confusing. When bond prices move up, interest rates move down and vice versa. This is because bonds tend to have a fixed price at maturity--typically $1000. If the price of the bond is currently at $900 and there are 10 years left on the bond and if interest rates start moving higher, the price of the bond starts dropping. The higher interest rates will cause increased accumulation of interest over the next 5 years, such that a lower price ( $880) will result in the same maturity price, i.e. $1000.