The Confusion Regarding the Fed Fund's Rate and Mortgage Rates

One of the greatest potential sources of confusion for prospective mortgage borrowers is the relationship between the Fed and mortgage rates. Although it is certainly true that the Fed's policy changes have a significant impact on all sorts of interest rates (including mortgages), a drop in the Fed's policy rate DOES NOT result in lower mortgage rates. In fact, the OPPOSITE was true yesterday following the Fed's decision to lower the Fed Funds Rate by a quarter point.

The main reason for confusion is the fact that there is a huge difference - from an investment standpoint - between a rate that governs the shortest-term transactions (the Fed Funds Rate applies to loans that last for 1 day or less) and a rate that can remain in effect for up to 30 years (in the case of mortgages). Even if we use the average life span of a 30-year fixed rate mortgage, we are still talking about 5-10 years depending on the broader market landscape.

You may have heard about the "inverted yield curve?" That's a reference to vastly different behavior between longer and shorter term rates, and it stands as evidence of the different sets of concerns that apply to each side of the duration spectrum. The differences are only more pronounced when we take the shorter end of the spectrum all the way down to the "overnight" level (Fed Funds Rate) and all the way up to the duration of the average mortgage loan.

Beyond the fact that a mortgage rate is very simply a different animal than the Fed Funds Rate, there's also the matter of frequency of movement. The Fed only meets to potentially change rates 8 times per year. Mortgage rates change every day - sometimes more than once in a day; and the bond markets that underlie mortgage rates change thousands of times per day. That means the mortgage market can easily, and quickly, get into position for any expected move from the Fed. In yesterday's case, where the rate cut was seen as highly likely, any effect that the Fed Funds Rate could ever have on mortgage rates was already priced-in weeks ago.

But let's say the first two points don't quite convince you, the third is irrefutable. The Fed doesn't just take the stage, cut rates, and go home. They release a plethora of other data-sets and hold a press conference to discuss their present and future policy decisions. The rates market (for mortgages, treasuries, and everything else) is tremendously interested in all that "other stuff." Yesterday, particularly, there was a set of updated forecasts for future rate movements and these were a bit less market-friendly than the average investor expected. In addition, market participants interpreted Chairman Powell's press conference as being a bit less friendly than expected.

Long story short: there are multiple reasons for mortgage rates to go their own way regardless of the Fed rate cut. In yesterday's case, mortgage rates were roughly unchanged from the day before. Interestingly enough, they were actually a bit lower yesterday morning, but many lenders raised rates in the afternoon due to the modest disillusionment with the Fed announcement (not the rate cut part, mind you... no one cared about that anyway... at least not anymore)!