Why Fed Rate Cuts Haven’t (and might not) Lower Mortgage Rates
If you are reading this article, you might be curious as to why the Fed rate cuts haven’t lowered mortgage rates like people said they would. After talking with multiple professionals in the mortgage and real estate industry, I found that they couldn’t tell me why…and to be honest, I didn’t have a solid answer for clients either.
It had been a few years since I took my last Econ class with Dr. Juan Arguez at Mercyhurst, so I decided to dive into the Federal Reserve’s surprisingly vast educational resources on their website. I will also give credit to the Chief Economist at First Trust, Brian Wesbury, who provides great economic insights weekly to my inbox.
The primary takeaway to this article should be that our financial system is very complex and there are a number of checks, balances, regulations and economic factors that affect mortgage rates. I think the first place to start is to understand that in the US, the 30 year fixed mortgage rate is almost directly tied to the 10 year US treasury bond.
Why are mortgage rates tied to the 10 year US treasury bond
Mortgages and 10 year treasury bonds fight for the same investors because they have a similar duration (length until bond matures) and risk profile. Since 2008, the US mortgage industry became more heavily regulated by the US government in the aftermath of the Financial Crisis of 2007-2008. This created a mortgage market with lower default rates, which is attractive for investors.
One way that banks make money is by “lending” out someone else’s money. This isn’t as cut and dry as George Bailey taking a part of everyone’s bank savings to lend out for mortgages. Banks will often get the funding for the mortgage (or home loan) by selling the mortgage to an investor simultaneously so that they don’t have to come out of pocket with the cash. They essentially match up an investor who wants a certain risk profile of a client and will accept a fixed interest rate to provide the cash. The bank charges the end mortgage recipient a slightly higher rate than they have to pay out and that is how they make money.
To increase their volume, banks will sell multiple mortgages together in packages to investors. In the investment world, these are called mortgage backed securities and they are often packaged together to have an average duration of 10 years. One would think that the 30 year fixed mortgage would have a duration of 30 years, however the average duration for these mortgage backed securities is often less due to the frequency of refinancing (for a lower rate or to get more cash/equity out of the home to spend elsewhere) and selling to move to a new home. There are also a number of other types of loans such as 3, 5, 7 year ARMs, 10 year and 15 year mortgages that they use to bring it down to the average duration of 10 years.
Since a US Treasury is considered a “risk free” asset and mortgage backed securities are tied to consumers that are at higher risk of defaulting than the US Treasury, there is usually a 2% risk premium that investors require for this. That is why you might see the 10 year treasury in the 4 - 5% yield range and the 30 year mortgage in the 6 - 7% yield range.
Now that we have made the connection between the 30 year mortgage rate and the 10 year US treasury bond, lets take a look at how bonds work and what affects the yield of the 10 year US treasury bond.
How Bonds Work
A bond is an investment that can be compared to a loan. You give someone money, they pay you interest payments while they have your money and then they give you your money back at a certain point in time.
Two terms associated with bonds that can be confusing are the interest rate and bond yield. The stated interest rate is the coupon or interest payment that is paid usually every 6 months. The bond yield is made up of two parts which includes the stated interest rate and the difference between the face value and market value (often called a premium or discount). The interest rate paid and the “yield” on a bond might differ depending on the market value of the bond.
When market values on new issue bonds fall - the “yield” becomes higher. For example, let's say the price of a 1 year bond is $975, you will get $1,000 back in 1 year and the bond pays you a 4% annualized coupon at 6 months and upon maturity . The yield is calculated as follows: $20 coupon paid at 6 months + $20 coupon paid at maturity + payback of $1000 (+$25 more than you paid) = $65 of earnings / $975 investment = 6.6% yield. In this scenario, this is a 4% bond that has a 6.6% yield.
Private companies, public companies and all levels of government utilize bond offerings to fund operations and projects. Similarly, the US Treasury, part of the executive branch of the US government, issues bonds to fund government operations. These bonds are seen as a safe haven (risk free) asset due to the low probability of defaulting (not paying you back).
The US treasury bond yield is based on supply and demand just like a private company bond. When supply is high and there are an excess number of bonds available and demand fails to keep up, the market value of the bond decreases (and yield increases). Here are four factors that affect the supply and demand of these US government bonds:
Government Deficit
It is no secret that the US Government has been spending more than they collect in tax revenue for a long time. The last time they operated at a surplus was under the Clinton administration in 2001. As of this writing, the US National Debt is over $35 Trillion and has been more than 100% of GDP for the last 10 years. This means that the US Treasury has to issue more bonds every year to cover their expenses. This increases the supply of bonds in the market.
Another factor to the ongoing deficit that doesn’t get enough attention is the fact that older bonds paid less interest. The last time rates on the 10 year Treasury bond were this high was 2007. That means that if the bond holders from the past 20 years have a bond that expires, the government must issue a new bond to pay them back and pay more interest to that new bondholder than they did the previous bond holder. It’s a compound effect that is going to continue to increase the amount of bonds the US Treasury must issue which again increases the supply of bonds in the market.
Inflation Risk Premium
Inflation, or the rise of prices for a basket of goods, causes investors to seek investments that provide a rate of return on longer term investments that will keep up with inflation. If buyers in the market think price inflation will persist, they will not buy an asset that produces a rate of return lower than inflation. This sentiment will drive up the yield on longer term bonds such as the 10 year treasury because the prices of these bonds will fall due to a lack of demand for a long term investment with a low coupon rate.
Foreign Exchange Rate
The value of the US dollar compared to other global currencies is due to the demand for the US dollar and US dollar denominated goods, services, and investments. There are a number of factors that can affect this including trade deficits, central bank interest rates, and economic strength.
The US led the charge economically from a global perspective coming out of the COVID-19 pandemic. This economic strength caused the US dollar to appreciate in value against most of the world’s other currencies.
Foreign buyers hold a little more than 10% of the US treasury bonds outstanding. When there is a currency imbalance (meaning the USD is too strong), countries will turn elsewhere to get more bang for their buck because the US dollar is too expensive. For example, it might cost $1,400 Canadian dollars to buy a $1,000 USD bond, so naturally there will be less investment due to the imbalance. If foreign buyers are buying less US Treasury bonds, the demand is lower which means the bond prices fall and the yield increases if supply stays the same.
Monetary Policy
The Federal Reserve System (the Fed) is not a branch of the US government and is the independent central bank that controls the money supply in the United States. The Fed is governed by the Federal Reserve Board of Governors (a government agency) and the 12 central banks located throughout the country. The Federal Open Market Committee (FOMC) makes decisions on monetary policy which is currently led by Chairman Jerome Powell.
Two of the primary ways that the Fed can manipulate the money supply is by open market operations and by setting the federal funds rate. The methods in which the Fed controlled the money supply changed somewhat significantly in 2006 (effective in 2008). In reaction to the Financial Crisis of 2007-2008 and in order to create more liquidity in the banking system, Congress gave the Fed the authority to manually set the Fed funds rate in addition to open market operations.
Open Market Operations
Open market operations is a lever that the Fed uses to buy and sell bonds which increase and decrease the supply of bonds and cash in the banking system. When the Fed buys US Treasury bonds, that puts more cash in the hands of the government to spend or give out, decreases the supply of bonds in the open market, drives up the price and decreases yield on treasuries. When the Fed sells US Treasury bonds, that increases supply, drives down the price of bonds and increases current yields.
As you can see in this chart, the federal reserve bought trillions of US Treasury bonds in 2020 to help fund the government’s fiscal stimulus packages during COVID (PPP loans, Biden Bucks, COVID shots, etc.). You can also see that since Q2 of 2022, the Fed has been selling the bonds it owns to reduce the amount of money in the banking system (in an effort to reduce inflation). This action increases the supply of bonds, driving prices down, and increasing the yield.
Federal Funds Rate
Now let’s look at how changing the federal funds rate can affect US treasury bond rates. As of 2008, the Federal Reserve now has the ability to “set” the federal funds rate when it used to be dictated by the buying and selling of bonds alone with a different set of rules that banks had to follow. The details of such changes can be found here.
Under the new system, the fed funds rate is an interest rate that the Fed pays banks for the amount they keep in reserves. This rate dictates the rate that banks lend money to each other which often affects things like your savings account interest rate, money market rates, consumer loan rates (auto loans, credit cards, personal loans), and short term treasury yields. When the federal reserve bank cuts the fed funds rate (as it started doing in September 2024), this action should decrease rates on consumer loans and increase economic activity by getting cash out of the bank and into the consumers hands to spend.
The lower fed funds rate will affect shorter term US Treasury bond yields which can drive bond investors towards longer term bonds that “should” produce a higher rate due to the longer investment duration (time held until maturity). In theory, this should produce a higher demand for longer term bonds such as the 10 year US Treasury bond. By increasing the demand for longer term bonds, this will cause the market price of the longer term bonds to increase, causing the overall yield to decrease.
Soft Landing
If you look at the Fed’s monetary policy over the past few years…as of June 2022, the Fed began selling bonds to reduce their balance sheet (from COVID) which increases the supply of bonds, in turn driving down the price and increasing the yield on longer term US Treasuries. As of September 2024, the Fed began lowering the fed funds rate to make it cheaper for banks to loan money out which should decrease longer term yields. One action is considered tightening and the other action is considered easing, so the net result should be zero.
The net zero stance should result in no major influence on supply and demand from the federal reserve standpoint. That means the natural market decides the yield of the longer term Treasury bond, which includes foreign buyers (who aren’t buying as much since their money doesn’t go very far with a strong US dollar), the US consumers who have been experiencing the highest inflation rate in over 30 years, and the US Government’s deficit that grows exponentially every day. All three increase supply, decrease price and increase yield.
In my opinion, the stock market’s reaction to Fed rate decisions 8x per year are clear misunderstandings of how the Fed operates under the new set of rules put into place with the “Ample-Reserve” model in 2008. Over the past 5 years, I haven’t once seen a news headline highlighting how many bonds the Fed sold last quarter, which could be arguably the most important lever that they pull in relation to bond and mortgage rates.
In conclusion, I hope you enjoyed reading this and have more insight as to how the banking system works in America. Over the past 100+ years, there have been changes in policies and procedures but nevertheless, the strongest economy in the world will continue to thrive no matter what the gameboard looks like.
References:
https://financeunlocked.com/discover/insights/ten-year-yields-rising-despite-fed-rate-cuts
https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
https://www.stlouisfed.org/in-plain-english/who-owns-the-federal-reserve-banks
https://fred.stlouisfed.org/series/FDHBFRBN
https://fred.stlouisfed.org/series/HBFIGDQ188S
https://fiscaldata.treasury.gov/americas-finance-guide/national-debt/
https://data.bls.gov/pdq/SurveyOutputServlet
https://fiscaldata.treasury.gov/datasets/debt-to-the-penny/debt-to-the-penny
https://www.sifma.org/resources/research/statistics/us-treasury-securities-statistics/#:~:text=Outstanding%20(as%20of%20December%202024,%2C%20%2B7.2%25%20Y%2FY
https://www.federalreserve.gov/econres/notes/feds-notes/closing-the-monetary-policy-curriculum-gap-20201023.html#:~:text=October%2023%2C%202020-,Closing%20the%20Monetary%20Policy%20Curriculum%20Gap:%20A%20Primer%20for%20Educators,the%20Fed's%20Ample%2DReserves%20Framework&text=The%20Federal%20Reserve%20(the%20Fed,the%20Fed's%20current%20implementation%20framework.
