Why Did Mortgage Rates Rise After The Fed Cut Rates?

The Fedreal Reserve cut its key rate by .5%, in conjuction with other central banks yesterday…and mortgage rates went up.  Scott Reckard highlights which loans should benefit over at the LA Times:

Home Equity Lines of Credit:

After the Fed lowered its benchmark rate by half a percentage point, to 1.5%, most banks followed as usual by dropping their prime rate by the same amount, to 4.5% from 5%. That could mean an instant rate reduction for many borrowers with credit card debt or a home-equity line of credit tied to a bank’s prime rate.

ARM s tied to treasury indices:

These mortgages typically fluctuate based on something other than the prime rate, and the two most popular indexes used to calculate these rates have behaved strangely in recent weeks and months because of the credit crisis.

The yield on one-year Treasury securities is used to calculate about a third of adjustable-rate mortgages, and the Libor — the rate that banks charge other banks for loans — is used on about half.

As panicked investors recently moved money into short-term Treasuries, the yield on the one-year T-bill tumbled to 1.18% on Tuesday from above 2% in early September. After the Fed rate cut, the yield rebounded to 1.24%. And it’s hard to say where the yield will go.

ARMs tied to LIBOR are headed higher though:

Conversely, the Libor has been much higher than normal, and the Fed rate cut may not help that much. That’s bad news for holders of subprime mortgages, which typically have a fixed rate for two or three years and then begin adjusting every six months based on the six-month Libor.

Why then, are fixed rate mortgage rates rising after the Fed cut its benchmark rate?

You’ve heard me say this before:  The major factor affecting fixed rate mortgages is the mortgage-backed securities markets, not the ten-year treasury bond, nor the Fed Funds Rate.  That market is what I watch when I write my mortgage rates report.  Last week, I said that we should see lower mortgage rates:

The market should remain volatile.  The par rate (with no yield spread premium to the originator) should drift as low as 5.625% in the next 60 days but it may have to go through 6.125% to get there.  If you’re planning on refinancing your home loan, get your documentation in line, watch the mortgage rates reports carefully, and jump on the opportunity when it presents itself.

I didn’t expect the Fed to cut as much as they did and neither did the MBS traders.  The prevailing fear, after a Fed cut, is that the results may be inflationary.  Markets are discounting mechanisms which means they anticipate or try to “guess” what the Fed might do.  In anticipation of a .25% cut, they bought mortgage bonds, driving mortgage rates as low as 5.875%. AFTER the Fed actually cut .5%, they worry about inflation, which erodes bond values and drives mortgage rates higher.

Is this an overreaction ? I think so.  While rate cuts COULD have an inflationary effect, it seems clear that our economy is slowing down rapidly.  While recessions are never good, they can have a positive effect on mortgage rates.  If economic indicators continue to point to an anemic economy, that can bring mortgage rates lower.

Why did mortgage rates rise? Because they already came down ahead of the Fed cut.

October 9, 2008