On Wednesday (3/20/18), the Federal Reserve board announced a 0.25% increase in rates. If your initial reaction was to worry or wonder about mortgage rates, this post is for you.
With interest rates up a half a percent or more since the first of the year, the interest rate market is a hot,–if not entirely happy–topic. In this post, I’m aiming to share some information about what drives interest rates (in general) as well as why rates have gone up so much in the past few months.
And (spoiler alert): That Fed announcement about higher rates had little-to-no impact on mortgage rates. (Phew.)
Before I get going, I want to add that I’m not an economist or bond market expert. I’m just a loan officer with a couple of decades of watching rates under my belt. Take these as the words of an enthusiastic amateur. I welcome comments, conversation and thoughts from readers with anything to add. Hit me up below!
So what drives rates?
The bond market drives mortgage rates. When you get a mortgage in the US, your lender gets the money from Fannie Mae or another similar entity. Fannie Mae gets its money by selling bonds to investors. If you’ve not already watched The Big Short, it looks a little like this:
Source: CMPS Institute.
The price investors are willing to pay for bonds determines the cost of the money. When demand is up, investors compete to buy bonds, driving prices up, and interest rates fall. When demand is down, investors sell bonds, driving prices down, and interest rates go up.
So far, so good. If we’re going to talk about what drives rates, we need to talk about what drives the bond market.
So then what drives the bond market?
In a word: Inflation.
Inflation has been virtually non-existent for years, as we made our way through the housing crisis and the great recession on our way to recovery and growth. Long-dormant, inflation is making a comeback.
Why does inflation drive rates?
Let’s say you have a little money you want to invest. To make a return on your investment, you need to think about inflation. Whatever you put your money into has to give you earnings that outpace inflation (and then some) or you aren’t really making any money. If you are worried inflation is on the rise, you will demand a higher return or you will go buy a different investment that seems more likely to beat the rate of inflation (like a stock instead of a bond).
But let’s say you decide to buy a Fannie Mae bond. Scroll back up to those smiley faces… you are lending Fannie Mae money to lend to mortgage companies to lend to borrowers. If you think inflation is on the rise, you will insist on a higher yield on your bond. Fannie Mae’s cost to borrow from you is higher and that rolls down hill from Fannie Mae to mortgage companies to borrowers.
What’s actually going on?
“Inflation” is still a little conceptual, so let’s talk about how the rubber hits the road in some practical ways.
Jobs reports and other economic data
It’s a little topsy turvy, but good economic news is bad news for rates and bad economic news is good news for rates. When the economy is thriving and growing and unemployment rates are low that growth can be the engine behind inflation.
As businesses expand in a growing economy, employers hire more workers. When unemployment is low employers need to offer higher wages to lure new staff… and probably need to give raises to existing staff to avoid losing them to competing employers. Whether workers spend or save and invest their additional income they stimulate the economy further.
Similar feedback loops can happen in other ways. Take the cost of raw materials to make things or the cost of fuel to move things around. In an expanding economy, business are competing for these things, and that competition puts an upward pressure on prices. HIgher prices is pretty much the definition of inflation.
Let’s go back to you and that money you want to invest. Besides a Fannie Mae bond, there are lots of other places you could invest your money and (needless to say) you want to get the best return you can.
When you buy a bond, you are buying the future interest payments someone is paying on a loan. When you buy a stock, you are buying a share of the assets and revenue produced by a business. If the economy is healthy and growing; putting your money into the stock market is usually the better bet. And further, you’d only consider buying bonds if the yield went up a bit to be more in line with the return you thought you were going to get on stocks.
In this way, the stock market and bond market compete with each other for investors’ dollars. I sometimes picture this like a balloon filled with money. (Work with me.) Imagine all the money currently invested in stocks and bonds is in this balloon. If you squeeze one end, the money is just going to squish over to the other end.
As a result, very often (most of the time) (but not always), when the stock market is on the rise, so are rates.
Political and world news
Political headlines, world news and events can also impact on rates. Stocks are, as we discussed, where investors like to put their money when they feel good about the economy. But what about when things get scary or weird (or scary and weird)? When bad or unsettling news hits the headlines, investors usually pull back from the stock market and buy bonds. It may not be much, but a steady trickle of income from a bond can feel like a safe bet when the stock market is on a roller coaster. For this reason, bonds are considered a safe investment and rates often improve due to bad news as investors buy bonds.
Supply and demand, Part I – mortgage bonds
Another major factor moving mortgage rates is the supply of and demand for mortgage bonds. Prior to 2008, the Federal Reserve owned zero dollars of mortgage bonds. In an effort to stimulate the economy during the mortgage crisis the Fed went on a mortgage bond buying spree. The goal: lower rates. And it worked.
With the Fed buying up mortgage bonds as they hit the market, they were able to create enough (more-or-less artificial) demand for bonds to drive rates to the low levels we saw from 2008 to the end of 2017. The Fed purchased $1.7 trillion (12 zeros) in bonds. 40% of the Federal Reserve balance sheet is made up of mortgage bonds.
Source: CPMS Institute
This reduction in demand had an impact on rates before it even happened. On May 22, 2013, Fed Chairman Ben Bernanke stated the Fed was thinking about (eventually) (but not yet) tapering its bond buying. 30 year rates averaged 3.59% on May 23rd and were 4.46% by June 27th (source: Freddie Mac). And it wasn’t until December 2013, that the Fed actually started to taper its bond buying.
Supply and demand, Part II – the deficit
The other supply and demand variable to watch is the level of Federal government debt. As of 2016, the Federal debt was $19.5 trillion. That’s a pretty staggering number, to be sure, but economists like to talk about public debt in context with the economy by using a “Public Debt to GDP” ratio. Of the $19.5 trillion we owed in 2016, $5.4 trillion was owed to ourselves (borrowed from the Social Security trust, for example), so our actual debt to others (private investors, foreign nations, etc) was $14.1 trillion, which is 76.22% of our, then, $18.5 trillion economy. By this measure, the US stacked up pretty well. Political rhetoric to the side, we actually ran a pretty tight ship when compared with other nations.
This is part of why our interest rates have been so low. The Treasury bonds we sell to fund our budget deficit look like a pretty good investment, since we are not over extended and seem likely to be able to continue to pay our debts. And even if our deficit grows, we can still be okay. If the economy grows by 2% ($370 billion) and the deficit grows by no more than $370 billion, the ratio remains the same.
But what if our deficit grows rapidly and faster than the economy? Well, then we could quickly have a problem. The Fed has just two options to fund the a deficit: 1) directly purchase government securities or 2) allow the private sector to purchase the securities. Both of these options increase the supply of money in the economy. More money sloshing around in the economy means higher prices. When the Fed has to flood the economy with new money to fund deficit spending, inflation follows. And these government bonds also directly compete with Fannie Mae bonds, further depressing prices and increasing rates.
The public debt to GDP ratio strongly correlates to long-term interest rates. One study I dug up estimated that a 1% increase in the ratio is projected to increase long term rates by .2% to .25%. A $1 trillion increase in the deficit could increase rates by 1% to 1.3%.
A ‘tariff’ is a tax on foreign goods and services, undertaken to protect an industry from foreign competition. Protectionism like this sounds pretty good if you’re working in a factory and don’t want your job moved overseas. But for the rest of us it means we pay more for goods from overseas and we wind up paying higher prices.
In the short term, tariffs can give the economy a small boost. People who would have lost their jobs to overseas competition keep working and spending into the economy. The government sees a boost in revenue from the taxes collected. But long term, protected industries have little incentive to invest in research and development and compete on the global stage. This dampening effect on innovation can lead to more job losses in the long run.
Tariffs are also likely to be met in kind by trade partners, triggering trade wars. When former partners in free trade impose their own retaliatory taxes on US goods and services, exports suffer and the US economy suffers with it. When the economy slows, the federal deficit grows further.
What is going on right now?
Bringing it all home, we have a lot of sound reasons that rates are up a little bit. I would argue we also have a lot of reasons rates are likely to continue to rise. Higher rates are partially attributable to some positive things: a healthy, growing economy, near-full employment and a bull run in the stock market. The next recession will come (they always do), and will bring lower rates with it, but I’m not going to root for it.
On the other hand, Congress passed a big tax cut cut taxes and then increased spending. That combination means the budget deficit will grow and the government will have to sell more Treasury bonds to pay its bills. And extra stimulus to an already-healthy economy may further stoke inflationary fires.
If you’re rooting for lower rates, the best we can hope for is our next recession, scary and weird news and/or for the new tariffs to slow the economy.
So far no recession on the horizon, but we have had more than a little weird, scary news of late. The weirder things get, the more likely bonds may come back in vogue as an investment, helping rates out. If the Democrats gain control of the House in the midterm elections and start impeachment proceedings, for example, I have a hunch the stock market will falter, bonds will rally and rates will improve.
And if the new tariffs slow the economy or generate enough tax revenue to slow the growth of the deficit, that could give bonds a leg up, as well.
Where can I watch rates?
The best way to keep tabs on mortgage rates is to watch the economic calendar and mortgage backed securities market (MBSs, as Wall Street types call them). Click here and bookmark my daily Bond Market Update and weekly Economic calendar. It’s a little geeky, but the best way to be in The Know.
What about the Fed?
The Fed has a mandate is to do two things: 1) keep as many people as possible employed and 2) don’t let inflation get out of control. Put another way: Make sure the economy is healthy enough to keep creating jobs without growing out of control and overheating.
The bond-buying the Fed did during the mortgage crisis (call “Quantitative Easing”) was an outside-the box measure taken for an outside-the-box situation.
In normal times, the Fed uses the rates it controls (the Federal Funds rate and Discount rate) like an accelerator and brake to speed up and slow down the economy, nudging it along.
They tap the accelerator of the economy by lowering rates (making it cheaper to borrow money, giving the economy a little boost when people and businesses borrow and spend). Or they can tap the brakes by raising rates (making it more expensive to borrow money, with the reverse impact).
So, when you hear the Fed has increased rates (as you are likely to hear a few more times this year), don’t panic.
The folks who buy and sell bonds pay close attention to everything the Fed says and does. The Fed knows this and sends lots of not-so-subtle messages to the bond market. This allows the bond market to go about its business, acting like the Fed has already done what everybody already knows it is likely to do. It is only when the Fed surprises the market or changes its messaging that dramatic moves in rates happen in connection to Fed announcements.
The Fed watches all of the variables outlined above (and more) (since I sure as heck hope they know more about all of this than I do) and adjusts messaging and interest rates as they see fit, always seeking a Goldilocks economy. Not too hot, not too cold… just right.
If you’ve read this far, you’re probably ready for some good news. I’m not going to tell you rates are coming back down any time soon–partly because I don’t have a crystal ball and also because I don’t think they are. I do have a few silver linings to share.
Impact of rate on payment
Anybody who talks to me about a mortgage will quickly learn that I love a good rule of thumb… it’s my favorite. Here’s a rule of thumb to keep in mind as rates change.
- On a 30 year loan, for every $100k of loan amount, a 0.125% increase in rate means about a $7.50 increase in payment per month.
If rates go up 0.5% and you plan to borrow $400k, your payment just got $120 bigger. That’s $7.50/mo times 4 (for the $400k loan amount) times 4 (because 0.125% x 4 = 0.5%).
There are way (way) funner things to spend $120 on than mortgage interest, but if you had to, you might be able to find $1440 a year to buy a home you really, really love. (And if you get lucky, maybe the property taxes on the home you really, really love will be a little cheaper than you were guessing and your payment will stay about where you’d hoped after all.)
Impact of rates on the housing market?
It is interesting to note that interest rates have less impact on the housing market than you might intuit. The factors that drive real estate prices are supply, demand and affordability.
Increasing interest rates does, of course, have an impact on affordability, but the impact is surprisingly small.
One recent study found that a 1% increase in interest rates would put homeownership out of reach for 5% of first time homebuyers. By contrast, increasing down payment requirements by 5% would put homeownership out of reach for 40% of first time homebuyers. So interest rates might be a less significant factor behind the housing market than you might guess.
Anecdotally, I suspect that’s because most of us could and would find that extra $120 in our monthly budget if we had to… especially if it means buying a home that better suits our lifestyle.
Rates are still pretty great
Let me just leave this here:
Freddie Mac, 30-Year Fixed Rate Mortgage Average in the United States [MORTGAGE30US], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MORTGAGE30US, March 18, 2018.
See that little tiny yellow dot way over to the right? That’s our current blip up in rates. For an interactive and less squinched version of this chart, click here. Are rates up? Yes. Are they still great? Boy, howdy.
Guaranteed Rate to the rescue
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Check us out
And of course, before taking about rates, finding the right loan option has to comes first. My team and I are here to help with that too… call or email any time.
We look forward to hearing from you!
US Federal Reserve Bank – St Louis
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