The Fed, interest rates and the dreaded ‘R’ word

A hawkish Federal Reserve approved its first interest rate hike in three years and Federal Open Market Committee members foresee six more hikes ahead. This past week the Fed announced it would increase the overnight lending rate by 0.25% meaning the new range is 0.25%-0.5%. Rates had been held at 0.00%-0.25% for the last two years during the heights of the COVID-19 pandemic. This was just the first move of what is expected to be six rate hikes this year alone. 

The very aggressive tone from FOMC members is an obvious strong move to try and curb rampant inflation which is at its highest point in 40 years. FOMC members predict the federal funds rate to near 2% by the end of this year and three more potential hikes in 2023. 

Consumers need to remember that the Fed does not set mortgage interest rates. When we talk about the Fed raising rates, we are discussing financing costs. Sometimes called the benchmark lending rate or the overnight lending rate, the federal funds rate is the rate banks pay to borrow and lend to each other. This cost is passed down to consumers in the form of credit card interest rates, auto and personal loan interest rates, etc.

The Fed's decision comes on the heels of a lot of headlines about a possible recession. We usually talk about the 10-year Treasury note yield as a good indicator of movement in mortgage interest rates. It is also what economists watch to look for signs of potential recessions. The two more important bond yields that economists track are the 2- and 10-year notes.

If the 2-year note yield moves higher than the 10-year note yield, that's called a yield curve inversion. That indicates short-term debt is more valuable than long-term debt. One inversion itself does not immediately predict a recession, however, multiple inversions over a short period of time have historically been indicators of recession. This past week the 5 and 10-year yield curves inverted but that is not as strong an indicator as the 2 and 10-year inversion. 

The main worry for economists is that the Fed has dug itself a deep hole by keeping interest rates so low for so long that now the FOMC will be forced to keep pushing interest rates higher even if growth slows. That would result in what's called stagflation. A senior market analyst at Asia Pacific, Jeffrey Halley, when interviewed by Reuters noted, “If central banks prioritize fighting inflation in 2022, having failed the world on that front in 2021, then hiking into a stagflationary environment likely means they are accepting some sort of recession is necessary to sort the whole mess out."

HOW DOES ALL OF THIS AFFECT MORTGAGES?

Raising the federal funds rate does not directly affect mortgage interest rates, however, economic growth and inflation do. Rates are rising because of the inflation factor but also because of the Fed's decision to taper its bond purchases. Over the last two years the Fed has been buying up pools of mortgage loans known as mortgage-backed securities (MBS) which built an artificial market with consistent demand. Taking that demand away means there are fewer buyers for the MBS so rates have to go up in order to be more attractive to investors. 

This past week rates hit 4.16 on average for a 30-year fixed-rate mortgage, according to Freddie Mac's data. It's highly likely that the originators participating in Freddie Mac's survey were already baking the Fed's rate increase into their own margins and raising rates preemptively. Unfortunately, the Fed is expected to continue to raise the federal funds rate multiple times over the course of the year which means mortgage interest rates will likely rise alongside the Fed's rate. Freddie Mac's economists note, "The 30-year fixed-rate mortgage exceeded four percent for the first time since May of 2019. The Federal Reserve raising short-term rates and signaling further increases means mortgage rates should continue to rise over the course of the year. While home purchase demand has moderated, it remains competitive due to low existing inventory, suggesting high house price pressures will continue during the spring homebuying season."