Mortgage rates are often thought to be directly linked to the Federal Reserve. It’s common for many people to mistakenly think The Federal Reserve actually sets mortgage interest rates. The media contributes to this misunderstanding. But it is incorrect. Mortgage rates are based on the pricing of mortgage bonds which are collateralized by mortgages, known as mortgage-backed securities.
The Federal Reserve
The Federal Reserve sets the Fed Funds Rate (FFR). The Fed Funds Rate is a short-term overnight rate banks charge one another to borrow money. Banks borrow money overnight to meet reserve requirements. This rate is a fixed interest rate and is a tool used by the Fed to manage the economy– either slow it down or speed it up. This rate is not tied directly to mortgage interest rates.
While the Fed does not set mortgage rates, its actions do have an influence over the mortgage market.
Mortgage interest rates are derived from the buying and selling of bonds, specifically mortgage-backed securities (MBS). Mortgage bonds trade all day long, every day of the work week. The price of a mortgage bond changes constantly throughout the day based on supply and demand.
Mortgage-backed securities and mortgage rates move in the opposite direction. As prices of MBS rise, mortgage rates fall. But there’s an easier way to think of it. When MBS prices improve, mortgage rates improve.
Mortgage-backed securities are an asset-backed security which is secured by a mortgage. Mortgage-backed securities are traded in the secondary market where lenders as well as private and public investors buy and sell every day. These securities are held by many institutions and sometimes may be found in retirement funds as they are a “safe” investment.
Influences to Mortgage Rates
The natural push-pull of supply and demand causes mortgage rates to rise and fall. Demand for mortgage bonds changes for a variety of reasons, however the most common is safety. In troubling times, investors flock to safe investments and mortgage bonds are a safe haven. When times are great, money leaves the safety net of the bond market and flowes into more exciting instruments such as stocks.
There are six primary factors that move the mortgage market. They influence safe haven trading which causes mortgage rates to rise and fall. These factors are commonly referred to as “fundamentals” and they are:
1. Inflationary Pressure
2. Economic Data
3. Stock Market
4. The Federal Reserve
5. Geo-poloitical News
6. World Events
Mortgage bonds react to the news, both good and bad. What is good for the economy is bad for mortgage bonds, thus mortgage rates rise. Conversely, bad news for the economy will tend to result in improvements to mortgage-backed securities and mortgage rates will move lower.
In the absence of economic, geo-political, and world news, bonds will respond based on technical factors. Technical factors are trends, moving averages, support and resistance levels…statistical type data.
Mortgage rates change with little or no advance warning based on the dynamics of the mortgage-backed security market. Make sure your mortgage lender is watching mortgage-backed security pricing in real time and has an understanding of how the bond market prepares and reacts to these key market movers.