The Federal Funds Rate is a short-term rate and its function is to make money more or less costly to borrow for homeowners and business owners depending on the economic environment at the time. Like the Federal Discount Rate, the Fed Funds Rate is used to control the supply of available funds and hence, inflation and other interest rates. Lowering the rate makes it less expensive to borrow and vice versa. A Fed cut increases the supply of available money which in turn decreases short-term interest rates and typically will help ignite a boost to the overall economy. Supply and Demand 101! The Prime Rate will be impacted along with Home Equity Lines of Credit, some credit cards, auto loans and business loans; but a direct correlation does not exist with mortgage rates.
A look at the 11 Fed cuts in 2001 showed that mortgage bond prices deteriorated after each rate cut, meaning mortgage rates rose. The consumers who were expecting rates to drop were in for a surprise.
Is a Fed rate cut really good news for mortgage rates? The facts may be surprising. The Fed can only control Discount Rate and the Fed Funds Rate. This is very different from mortgage rates. A mortgage rate can be in effect for 30 years, a rate that is set by the Fed can change from one day to another.
Another common mistake is in thinking that the 30-year Treasury bonds or 10-year Treasury notes are directly pegged to mortgage rates. Those are government securities that are backed by the full faith and credit of the U.S. government and have no direct effect on mortgage rates.
So what are mortgage rates based on? As it turns out, the answer is...mortgage-backed bonds known as Mortgage Backed Securities (MBS), a global exchange similar to the New York Stock Exchange and NASDAQ and traded everyday.
Mortgage-backed bonds are considered long-term products and pricing is based on long-term expectations of the U.S. economy and the U.S. dollar. Bonds issued by Fannie Mae and Freddie Mac (MBS) and the trading performance of those bonds will determine the direction of mortgage rates. Finding the catalyst that causes mortgage bonds to move will give you the key to finding out what makes mortgage rates rise or fall. We already know that inflation will always be a negative for any long-term bond because it eats away at the future returns. Since the bond will pay a set amount over a long period of time, that amount will be less valuable if inflation is high.
In closing, containing inflation and creating economic growth are the main objectives of the Federal Reserve and the reasons why they choose to manipulate the Fed Funds Rate. The reason for the last cut was an attempt to spark the economy and jump-start it from the slowdown we have been experiencing. More importantly, they are trying to keep us from entering the "textbook definition" of a recession.
Source:
Richelle Lynch
Bear Stearns
FOR MORE INFORMATION, PLEASE CONTACT SCOTT DAVIS, SUNTRUST MORTGAGE, 703-209-3138 or SCOTT.DAVIS@SUNTRUST.COM
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