Conventional wisdom says that when the Feds cut rates, mortgages rates go down. However, it is also possible for mortgage rates to in fact increase! This is exactly what happened last week when the Feds provided a second significant rate cut in as many weeks. Why does this make sense? We must separate the long term and short term effects of rate cuts.

The long term effect of Fed rate cuts is to drive the mortgage rates down. When rates are cut, this allows banks to borrow from each other and the Federal government at a lower rate. Hence, banks can offer loans at a lower rate and still make the same profit. Due to bank competition, this is exactly what happens.

However, the short term effect of Fed rate cuts can have just the opposite consequence! Check out this chart from Bankrate of the national average 30-year fixed rate mortgage rates of the last few months.

bankratemortgagrates.png

You can clearly see the mortgage rates drop, but then slightly rise back up recently (the rate cuts!). Here’s what’s happening. The Fed’s cut the rates to stimulate the economy. That is, they wanted to help companies and also soothe investor confidence. Make no mistake, the emergency rate cut of two weeks ago was partly a response to the stock market’s recent nose diving. And the rate cut has helped the stock market (the Dow is up roughly 4.8% in the last 10 days). But with investors reinvesting in the stock market, that means they aren’t investing in bonds (the usual coupled relationship between stocks and bonds). So in response, bonds must offer a higher yield to compete with the stock market and get investors. Of course, bonds are nothing more but repackaged loans sold off as investments. Therefore, the loans that make up these bonds must be at a higher rate. And there you have it. The immediate short term effect of Fed rate cuts actually increases mortgage rates!

A day or two after I had read this in the above linked article, I actually spoke to my mortgage broker (I’ve been getting pre-qual’ed) about it too.  He reiterated the short term effects, and even suggested following the 10 year T-Bill for a more accurate tracker of mortgage rates.