https://www.financialsamurai.com/the-federal-reserve-doesnt-control-mortgage-rates-the-market-does/
Ever wonder why mortgage interest rates sometimes don’t decrease when the Federal Reserve cuts interest rates and vice versa? The simple answer is that the Fed does not control mortgage interest rates. The bond market does.
The Federal Reserve controls the Fed Funds Rate (FFR), which is an overnight interbank lending rate. An overnight rate is the shortest lending term, which means shorter duration lending rates such as credit card interest rates and short-term car loan interest rates will be affected.
However, mortgage rates have longer duration lending terms. Therefore, longer duration U.S. Treasury bond yields have a far greater influence on mortgage interest rates than the FFR.
After the Federal Reserve slashed its Fed Funds Rate to 0% – 0.25%, mortgage rates actually went up because US Treasury bond yields went up by ~0.5%.
The increase came about partly as a result of Congress’ approval of a major spending package aimed at curbing the economic impact of the coronavirus, as well as discussions of a broader, more expensive stimulus package now known as the CARES Act.
The plan will require a large amount of government debt to be issued, in the form of U.S. Treasuries. Knowing that more bonds will be in the market, current Treasuries suddenly warranted lower prices, which resulted in higher yields.
Mortgage rates and Treasury bond yields also went up after the emergency rate cut because of the negative signaling by the Fed. If the Fed couldn’t wait three days to cut rates during its policy meeting, then things must be really bad. As a result, investors indiscriminately sold everything to raise cash.
Finally, mortgage rates went higher after the Fed cut the FFR due to expectations for higher prepayments which degrades investor returns and creates high gross supply of Mortgage Backed Securities.
The Federal Funds Rate is the interest rate everybody is referring to when discussing cutting or increasing interest rates. The FFR is the interest rate that banks use to lend to each other, not to you or me.
There’s generally a minimum reserve requirement ratio a bank must keep with the Federal Reserve or in the vaults of their bank, e.g. 10% of all deposits must be held in reserves. Banks need a minimum amount in reserves to operate, much like how we need a minimum amount in our checking accounts to pay our bills. At the same time, banks are looking to profit by lending out as much money as possible at a spread (net interest margin).
If a bank has a surplus over its minimum reserve requirement ratio, it can lend money at the effective FFR to other banks with a deficit and vice versa. A lower effective FFR rate should induce more inter-bank borrowing which will be re-lent to consumers and businesses to help keep the economy liquid.
This is exactly the outcome the Federal Reserve had hoped for when it started to lower interest rates in September 2007 as the economy began to head into a recession.
Study the historical Effective Federal Funds Rate chart below.
By the summer of 2008, everybody was freaking out because Bear Sterns had been sold for a pittance to JP Morgan Chase. And then on September 15, 2008, Lehman Brothers filed for bankruptcy. Nobody expected the government to let Lehman Brothers go under. But when it did, however, that’s when the real panic began.
What happens when everybody freaks out? Banks stop lending and people stop borrowing. This is what economists call “a crisis of confidence.” Consequently, the Federal Reserve lowered the FFR in order to compel banks to keep funds flowing. Think of the Federal Reserve as attempting to keep the oil flowing through a sputtering car engine.