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Is The Fed Ready To Fall Back?

The U.S. Federal Reserve and Mortgage Rates

Rob Chrisman
Insider
Rob Chrisman
A close-up on the federal reserve seal on a 20 dollar bill.

Due to the impact of the pandemic, last March the Federal Reserve cut short-term interest rates to zero and restarted its large-scale asset purchases (known as quantitative easing, or QE). Since July 2020, the Fed has been buying $80 billion of Treasury securities and $40 billion of agency mortgage-backed securities (MBS) each month, but there has been a lot of “tapering” talk recently, which would mean slowing the pace of bond purchases. What does this all mean for mortgage rates and borrowers?

Many people believe the Federal Reserve, through the Federal Open Market Committee (FOMC), has a direct impact on mortgage rates. That is untrue. While it does not directly control mortgage rates, its influence on the bond market can indirectly manipulate rates. “Monetary policy” refers to open market operations by the FOMC, or changes to the discount rate and reserve requirements. Additionally, remarks from FOMC members, primarily the presidents of the various Federal Reserve districts, and announcements of what the Fed is doing serve as useful predictors of future rate movement more so than the level of the Fed funds rate. 

That being said, residential real estate is on average the biggest asset most people own and the Federal Reserve doesn’t want to risk weakening the economy during a pandemic by letting mortgage rates rise.

Picture Perfect?

It should be stressed that the same economic events which influence day to day bond markets, and therefore interest rates, influence the thinking of the FOMC. Job growth, inflation, supply chain snags, housing appreciation and so on all contribute to a picture of the economy, not only where things have been, but the projections of where things are going in the future. 

The Federal Reserve operates under the dual mandate of maximum employment and price stability. It achieves these aims through actions that do not directly move mortgage rates. Among these functions are changing the discount rate, bank reserve requirements, conducting open market operations and altering interest on reserves. The Federal Reserve sets borrowing costs for shorter-term loans in the U.S. by moving its Federal Funds rate (Fed Funds), currently set near zero. The rate governs how much banks and depository institutions pay each other in interest to borrow funds from their reserves kept at the Federal Reserve on an overnight basis.

The Fed Funds rate affects short-term loans, such as credit card debt and adjustable-rate mortgages. Long-term rates for fixed-rate mortgages are generally not affected by changes in this rate, but track the 10-year U.S. Treasury rate much more closely, and arguably the 5-year or 7-year Treasury securities. The anatomy of a primary mortgage rate is the corresponding Treasury yield plus the MBS spread plus the Primary/Secondary Spread. Through rate cuts and quantitative easing, the Fed has applied overwhelming downward pressure on MBS spreads. The Federal Reserve’s playbook is to support the economy by supporting asset prices.

Strong Influence

Though a rate cut by the Federal Reserve doesn’t directly push down yields on the 10-year Treasury, it can lead to the same outcome. Investors worried about the economy around the time of a rate cut might push their money into the safe-haven of the 10-year Treasury, increasing the demand for these securities and pushing down yields, and thus mortgage rates. When investor demand in the secondary marketplace is high, mortgage rates trend a little lower. When investors aren’t buying, yields may rise to attract buyers. 

Every lender should know that mortgage rates are made up of a complex interaction of capital market pricing, the costs associated with credit enhancement, and the valuation of the servicing asset. The actual rate determination process is influenced by supply and demand and relies on the calculation of the optimal security coupon, so there is much more than the Federal Reserve at play. Federal Reserve policy has dominated valuations of MBS ever since Federal Reserve purchases under QE1 and QE3 in 2008 made the U.S. Government the largest holder of MBS. At its peak, the Federal Reserve owned nearly one-third of all Agency MBS, but balance sheet runoff has dropped its holdings to closer to one-fifth of currently outstanding Agency MBS. The result is that Federal Reserve balance sheet policy is the primary driver of MBS spreads, a key determinant of MBS valuations.

Pandemic Response

The disruption in the Treasury market at the start of the pandemic made the cost of borrowing money more expensive than the Fed wanted. In response, the Federal Reserve announced it would buy billions of dollars in Treasuries and mortgage-backed securities, or MBS. The move was to support the flow of credit, which helped push mortgage rates to record low.

And quantitively, through the actions of the New York Fed’s Trading Desk, the Fed is purchasing $4-6 billion per day of Agency mortgage-backed securities. Interestingly enough, the approximate production of Agency loans by lenders around the United States is roughly the same amount. So any change in the form of tapering could be met with increased mortgage rates.

It's a balancing act by the Federal Reserve as it not only promotes maximum employment and stable prices for the American people but stabilizes the financial system. The Federal Reserve does have some sway over rates with not only its commitment to moving short-term interest rates as appropriate, but also its purchase of a wide variety of assets, and its aggressive injections of liquidity. 

As long as the Federal Reserve continues to support MBS prices via its purchases of mortgage-backed securities in order to support the economy, the Fed has an influence on mortgage rates. But we should all be prepared for the tapering off of purchases and the impact of this on mortgage rates.

This article was originally published in the Mortgage Banker September 2021 issue.
Rob Chrisman
Rob Chrisman

Rob Chrisman began his career in mortgage banking – primarily capital markets – 35 years ago. He is on the board of directors of Inheritance Funding Corporation, of Doorway Home Loans, of AXIS Appraisal Management, and of the California MBA. He is also a member of the Secure Settlements Advisory Board, an associate of the STRATMOR Group, and of the Mortgage Bankers Association of the Carolinas and its membership committee.

Published on
Sep 08, 2021
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