Interest Rates Explained

Interest Rates Explained

Why mortgage rates can go up even if the Fed drops rates.  There are a couple answers to this question

1.    Mortgage rates are actually based on the 10 year treasury, not the fed funds rate. Both mortgages and the 10 year treasury are long term instruments.  A ten year treasury bond pays coupons every year and after 10 years the note is due. This actually has a similar “duration” as a mortgage that pays an equal payment over 30 years. The fed funds rate is a short term rate and not directly related.

So when the Fed lowers the short term rate, long term rates may not go down in tandem, they may stay put, increasing the spread between long term and short term rates. With commodities like oil and gold at all time highs, and government spending somewhat out of control, there are a lot of inflation fears. Lowering short term rates has just bent the yield curve.

2.    The spread between the 10 year treasury and mortgages is growing towards record levels. Despite what is going on with “risk free” interest rates, the market is understandably much more skeptical about the risk of mortgages vs. the US government.  So there is not much the Fed can do.

3.    The private mortgage backed securities market is still pretty close to dead, and showing few signs of life.  This surprised me a bit. A trillion dollar market disappeared over 48 hours and is showing no signs of life. This is part of a much bigger credit crunch that could last years.

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