Jan 22 2008
What goes up…Must come down
Steve Adams with 1st Independence Mortgage gives us a great update on today’s market performance.
Steve Adams - Mortgage Broker - 1st Independence Mortgage
So the Fed cut rates! What does this mean for you? Will your mortgage rate come down? Is it time to refinance? Maybe, but probably not. First the good news, the prime rate will almost certainly drop by the same amount as the Fed Funds target rate. Therefore a reduction in the Fed Funds Target rate will certainly help you if you have an adjustable mortgage that is tied to Prime such as a home equity line of credit. A cut in the Fed Funds Rate will also translate into savings for you on credit cards that adjust according to the prime rate. A cut in the Fed Funds rate may also help with adjustable loans tied to other indices besides prime. The rates that the Fed directy affects tend to apply to extremely short term borrowing, such as overnight loans to member banks. The effect of these rate movements tend to rub off a little bit on other short term rates. If your adjustable mortgage is tied to another short term instrument like a 6 mo. treasury bill, or perhaps CD rates, then this move may cause your mortgage rate to ease a bit over time.
What About Fixed Rates?
You may be surprised to learn that a Fed action like this may not help fixed rate mortgages at all. In fact past Fed rate cuts have been known to drive fixed rates higher sometimes.
Fixed rate mortgages respond mort to what the Fed says then what the Fed does when they announce any changes. Fixed mortgage rates are much more focused on the prospect of inflation than any movement in very short term rates. Longer term fixed rates are moved by what the Fed says about inflation about inflation in particular. Lets suppose for a second that you are the lender. In fact you may very well be a lender and not know it. I will talk about that in my next post. Lets say you are a lender and you have made a fixed rate 30 year mortgage loan to a homeowner at 6.5%. Lets say over that period inflation averages 2.5%. Each year your investment would earn 4% after inflation. If inflation were to rise to 4.5% your earnings would be reduced by 50% to only 2% per year. For this reason inflation tends to be the primary enemy of the fixed rate investor.The Fed has been using the Fed Funds and Discount Rate as tools to try to keep inflation in check. They will typically raise rates to slow the economy if inflation danger arises. If inflation is low and the economy appears soft, the Fed can lower rates to try to stimulate the economy however lowering the rates also tends to stimulate inflation at the same time. The net result is that lowering short term rates may actually put upward pressure on long term rates, and vice-versa.For some time, the Fed has been trying to balance the risk of allowing our economy to slow, with the risk of stimulating inflation which is already running in the upper end of their target rate. For this reason, the effect on long term rates is not so much the result of what the Fed does, as what it says as it does it.At the previous meeting, most bond market watchers felt the Fed would be more concerned about the strength of the economy and therefore expected a .25% cut by the Fed. The real question was what they would say about it. What they said was they viewed the risk of inflation is just about equal to the risk of economic slowdown. The Fed said they recognize the slowing in the economy and are going to go ahead and cut .25% this time but do not expect us to automatically cut each time because we still see a threat of inflation on the horizon. Because they pointed out a threat of inflation but stimulated the economy anyway, investors saw the move as inflationary and we actually saw long term rates rise a bit in response.
Just prior to this meeting, Wall Street pundits became convinced that the Fed would acknowledge that growing signs of a slowing economy would certainly outweigh any threat of inflation. They seemed to be calling for the Fed to cut their target rate as much as .50%. In other words the Pundits wanted the Fed to signal a definite change in their “bias” toward helping to spur the economy, from being equally concerned about inflation. This mounting cry from the pundits seemed to actually cause upward pressure on long term rates over the few days leading up to the meeting.
The actual announcement of a .25% reduction in both the Fed Funds Rate and the Discount Rate was met with great disappointment from every single one of the pundits interviewed on CNBC. Jim Cramer appeared absolutely despondent. I wonder how much of the disappointment may be the result of a realization by these pundits that they can not dictate their desires to the current Fed Governors and get what they want each time. The Fed comments that accompanied the move continued to show concern for keeping inflation in check. In any case the more modest cut will perhaps be less inflationary than what the pundits called for so long term interest rates may edge back down.
