Since the middle of 2004, the Fed has raised short-term interest rates by 1.75% from historic lows yet during this time period mortgage interest rates have actually declined. Likewise, in the past when the Fed has lowered interest rates, mortgage rates have actually risen. This phenomenon is strange but true…
But how does this work and why? Although it may seem counter-intuitive at first, it really does make perfect sense.
First, put yourself in the position of a mortgage bondholder… like the mortgage lender. If you lend the money, you receive interest over time. If that were a mortgage, it could be a full 30 years worth of repayments and interest. Let’s say you were going to be receiving $1,000 per month for the entire 30-year term. At first, that $1,000 may be a very fair return, as you calculate what you can do with that money every month. But over time, inflation requires that you spend more money to purchase the very same goods and services that you can purchase today for less. That same $1,000 just doesn’t go as far in future years as it does today. This eats away at the value of a long-term fixed instrument like a bond or a mortgage, and explains why inflation is the main enemy of bonds. Because bond investors are very aware of this, they will require a higher rate of return or interest on their investment to compensate them, if they feel that inflation will be increasing.
In today’s improving economic environment, inflation is expected to be on the rise. In response, interest rates on long-term bonds, like mortgages, have moved markedly higher in expectation of this. Interestingly, the increase in mortgage rates during the first half of the year has occurred without any movement by the Fed, and some mistakenly think that this is anticipation of a Fed rate hike. Not true. Reality is that bond rates are simply pricing in the expectation of higher inflation over time.
Now think about it – a move to tighten or hike rates by the Fed is designed to slow inflation, and we can now see why tempering inflation is very good news for bond holders or mortgage lenders. With inflation reduced, the buying power of their future returns will face less erosion from the effects of inflation.
So believe it or not, this is why a Fed rate hike actually helps reduce mortgage rates.
-Written by Barry Habib, CEO of Mortgage Market Guide
Contributed by Evan Swanson, Senior Loan Officer, Continental Home Mortgage