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Fed Rate Cut FAQ’s

What exactly is a “Fed Cut”?

Many people talk about “Fed cuts” and assume they apply to all loan types of loan rates. Reality is that the Federal Reserve does not directly control all loan rates, in fact, they only control one rate. The Fed cut actually applies only to the “Federal Funds Rate” which is a rate that the Fed charges banks to borrow short term money. Many banks also tie certain types of adjustable-rate loans they offer to customers to this fed funds rate. The “Prime rate” is an example of a rate structure created by banks that ties directly into the Fed funds rate (Prime rate generally is calculated as Fed Funds Rate + 3%).

Does a Fed Cut Directly Correlate to Home Loans (mortgage rates)?

Short answer is NO. Repeat, short answer is NO. The capital (money) needed to provide a trillion dollars’ worth of home mortgages is way beyond the capacity of our banking system, so this money comes from the BOND MARKET. Mortgages are bundled up and sold in packages (mortgage backed securities, aka MBS) on the open bond market. These MBS are bought and sold daily, and the daily pricing in the bond market is based on FUTURE expectations of the overall economy, inflation, and long term expectations of rates overall.

So please understand that the bond market (often called the smartest market) will adjust daily to future expectations. So if there is any expectation by bond market investors of slowed economic growth, an anticipated Fed funds cut, or any hiccup in the economy, bond market rates and therefore mortgage rates, will adjust almost immediately. The Fed and also bond market investors both look at the same data, but the bond market is able to adjust pricing and trading to reflect current expectations daily, versus the Fed making only period cuts during the course of a calendar year. So long story short, the bond market is generally way ahead of the Fed.

So this most recent Fed cut was largely already expected by the bond market, (and therefore mortgage rates) and was already largely priced into today’s rates sheets (the big drop in mortgage rates seen the past two weeks was the bond market reacting ahead of this latest Fed movement).

Why did the Fed cut rates, and what is the expected result?

The Federal Reserve cut the Fed Funds rate primarily to create positive stimulus for companies and consumers to spend money and make investments. Business loans are held primarily by banks, and are directly impacted by Fed cuts. So making it cheaper for businesses to borrower, may incent them to move ahead despite uncertain economic conditions associated by the Coronavirus.

Keep in mind that if the Fed is successful in helping stimulate the economy and help businesses grow and prosper, this will ultimately lead to HIGHER mortgage rates as investors will choose to invest more intensively in the stock market at and remove funds from the bond market. This decreased demand for bonds will ultimately put upward pressure on bond yields (and mortgage rates). The better the economy does, it creates appreciation in the value of stocks, but also increases inflation pressures. Preference by investors for stocks, and corresponding acceleration in inflation are enemies of bonds (and mortgage rates).

Where will rates go from here?

There is no clear answer at this point, but we are already sitting at historical lows. The virus impact globally has yet to be quantified. Even if the virus does not spread materially further, it has already created a disruption that will work its way through the global economy over the next several months. If the spread continues, more disruption will further reduce economic expectations, and therefore investors will continue to prefer to hold money in the safe-haven investment of bonds over the riskier choice of stocks (which are dependent on business profitability and therefore solid economies).

There is a tremendous amount of reluctant money invested in bonds today, so the risk of bond rates (and

mortgage rates) rising quickly on any good virus containment news could be greater than a further material drop in rates beyond this already low historical level.

Should you lock in a rate?

If there is one thing that seasoned investors learn quickly, and that is timing the market is difficult or impossible. If purchasing a home, look at the corresponding payment associated with a loan rate and decide if works in your budget as your primary decision-maker. For refinances, determine if there is a material cost savings available with the current rate market. If the numbers are attractive, make that your primary decision-maker.

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Investment advisory services offered through Arete Wealth Strategists, a Minnesota Registered Investment Advisor. Telephone number 888.544.3250. Arete Wealth Australia may offer investment advisory services in the State of Minnesota and in other jurisdictions where registered or exempted. Please click here for more important disclosure

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