The Importance Of Language

Adjectives play an important role in the English language -- they modify nouns.  Because of adjectives, we can linguistically separate good movies from bad movies, rainy days from sunny days, and sore losers from lovable losers.

Sometimes, adjectives are superfluous.  For example, you know this is a mortgage blog so when yours truly writes "rates are lower", it's implied that I'm talking about mortgage rates. I don't need to constantly say "mortgage rates".

Other times, though, omitting adjectives leads to misunderstandings. It happens nearly every time the Federal Open Market Committee meets.

Here's why.

Explaining the FOMC In Layman Terms

The Federal Open Market Committee is a government group that makes monetary policy. It's job is akin to the gas-and-brake pedals on a car -- speed up or slow down the vehicle that is the U.S. economy.

The FOMC has 12 members and is headed by Chairman Ben Bernanke.

8 times annually, the Fed gets together to discuss a host of economic issues and, when the meeting is done, the members vote on whether to raise, lower, or leave unchanged an interest rate called the Fed Funds Rate.

The Fed Funds Rate is the prescribed interest rate at which banks lend money to each other overnight.

Simplified, when the Fed Funds Rate is high, banks end up paying a lot of money in interest payments and are less inclined to borrow from one another, thereby slowing down the economy. When the Fed Funds Rate is low, borrowing is cheap, and the economy is spurred forward.

Because the Fed Funds Rate is directly related to Prime Rate, the basis of business and consumer borrowing, the FOMC's vote carries huge implications for the economy as a whole.

The FOMC Does Not Vote On Mortgage Rates

The FOMC meets today and adjourns at 2:15 PM ET.  The group is expected to leave the Fed Funds Rate unchanged within its current range of 0.000-0.250 percent.  This is the lowest Fed Funds Rate is history and the Fed has said that the Fed Funds Rate will stay near zero for "an extended period".

However, by 2:30 PM, news stories will surface online about how the Fed voted to "leave rates unchanged" today.

And this brings us back to adjectives -- implied or otherwise.

See, the proper verbiage from the press would be "the Fed voted to leave the Fed Funds Rate unchanged today", but that's not how the headlines will be phrased.  They'll just say "rates".

This is a big deal only because most Americans don't know what the Federal Reserve's true scope is; they never learned what the Fed does for the country, or how it does it. It's the main reason why, in my experience, Americans tend to think that the Federal Reserve controls daily mortgage rates.

It doesn't. But... Because of this misconception, when Americans read about the FOMC and "rates", they just assume the story is about mortgage rates.

It's not.

Comparing The Fed Funds Rate To Mortgage Rates

The FOMC doesn't control mortgage rates.  If it did, the chart at top would be less staggered.

Going back 20 years to 1990, the relationship between the Fed Funds Rate and the 30-year fixed rate mortgage has been indirect, at best.  The spread in rates has been as narrow as 1 percent and as wide as 5 percent.  There was even a period in the 1970s and 1980s where the spread went negative; where mortgage rates were lower than the Fed Funds Rate.

And if you need to know the biggest reason why the Fed Funds Rate is untied from mortgage rates, it's because the Fed Funds Rate is an overnight rate and the 30-year fixed rate is a long-term rate.

Borrowing money is much different over 8 hours as compared to 263,000 hours.

Make A Mortgage Rate Lock Plan Ahead Of The FOMC

It's imprudent to float a mortgage rate ahead of an FOMC meeting. Despite the near-universal belief that the Fed Funds Rate won't be changed, there's always the chance that the Fed says something "good" for the economy, causing mortgage rates to spike.

It's happened in the past and it could happen again.

If you're shopping for a mortgage or otherwise not locked in, talk to your loan officer in advance of the Fed's 2:15 P.M. ET announcement. Rates may not rise, but then again, maybe they will. It stinks to be on the wrong side of that bet.

Or, if you don't have a loan officer, with your details and I'll lock your rate for you on the spot.

The Federal Open Market Committee starts a 2-day meeting today and will vote to keep the Fed Funds Rate unchanged. Don't expect mortgage rates to stay unchanged, too, however.  The Fed Funds Rate and the 30-year fixed mortgage rate are two completely different animals.

Yet, people confuse them all the time. Here's what you need to know.

Conforming Mortgage Rates Are Made On Wall Street

The Federal Reserve controls two interest rates -- the Fed Funds Rate and the Discount Rate.  Both are "banking" rates.  Neither is a consumer rate.

When the Federal Reserve makes a vote on the Fed Funds Rate, it's voting on the rate at which banks borrow from each other. The Federal Reserve is not voting to change consumer mortgage rates because, based on its government charter, it can't.

Therefore, if you're looking for somebody to tell you where mortgage rates will go, don't look to the Fed.  Look to Wall Street instead. Mortgage rates are the by-product of mortgage-backed bonds and their respective prices. The Federal Reserve has nothing to do with it.

If the Fed controlled mortgage rates using the Fed Funds Rate, the interest rate spread between the two would be liner.

Clearly, it's not.

Ben Bernanke Influences The Mortgage Market

Now, all of that said, the Fed is not without influence on mortgage rates.  This is because the Federal Reserve is our nation's Central Banker and its policies set the tone for the equities markets.

For example, when the Federal Reserve makes positive comments about the economy, the stock market tends to gain and those gains come at the expense of bonds.  Similarly, when the Fed is down on the economy, stock markets often sell off and bond markets get the benefit.

Simplified:

• Rates rise when the Fed is unexpectedly positive on the economy
• Rates fall when the Fed is unexpectedly negative on the economy

This is why it doesn't matter how the Fed votes tomorrow.  It'll be the group's post-meeting press release that sets the tone for mortgage rates.

It's imprudent to float a mortgage rate ahead of a FOMC meeting.

Call In Your Rate Lock ASAP

If you're shopping for a mortgage or otherwise not locked in, talk to your loan officer in advance of the Fed's 2:15 P.M. ET announcement tomorrow. Rates are more likely to rise than to fall.

Or, if you don't have a loan officer, with your details. I'm happy to get your rate locked right away -- before rates change for the worse.

The Federal Reserve begins a scheduled 2-day meeting today during which it which it will vote to leave the Fed Funds Rate unchanged near zero percent.  The press will report this tomorrow as "Fed Holds Rates Steady".

But, don't confuse this to mean that the Fed held mortgage rates near zero. The Fed doesn't set mortgage rates.  The Fed sets the Fed Funds Rate. The former is a long-term rate and the latter is a short-term rate.

The Fed Funds Rate and the 30-year fixed mortgage are two different animals.

The Fed Funds Rate is set by the Federal Reserve to accelerate or retard economic growth.  Mortgage rates are set by price of mortgage-backed securities at any given moment plus any applicable loan-level pricing adjustments. If the two were directly related, the chart above would be linear.

Instead, it's got more steps than the cover of Houses of the Holy.

Since 1990, the spread between the Fed Funds Rate and the 30-year fixed rate mortgage has been as narrow as 1 percent and as wide as 5 percent.  Going back even further, to 1973-74 and then again to 1980-81, there's been instances of the interest rate spread going negative; mortgage rates were below the Fed Funds Rate.

Hopefully it's clear now. Mortgage rates and the Fed Funds Rate move independently. The Fed doesn't set mortgage rates.

However, it does influence them.

As the nation's central banker, the Federal Reserve sets policies that change the U.S. economy's direction and changes in the economic happen to make a huge impact on mortgage rates.  It's one reason why mortgage rates were so volatile in 2009 -- the future of the economy was a giant glob of murk and as Wall Street did its bidding, rate shoppers got tossed along for the ride.

So, let's ignore what the Fed will or won't do tomorrow and focus instead on what the Fed says.

See, when the Fed adjourns, it issues a statement in which Bernanke & Co address the nation's economic strengths, weaknesses and threats. If the Fed's statement shows optimism for the economy in its statement, mortgage rates will rise as money flows away from the safety of the mortgage-bond market.

If the Fed's statement show pessimism, on the other hand, mortgage rates will fall.

Either way, be on alert.  The Fed statement hits at 2:15 PM ET Wednesday.

For Cincinnati home buyers and homeowners shopping for low mortgage rates, you must understand the difference between the Fed Funds Rate and a long-term mortgage rate. When you do, you're more likely to lock a mortgage rate on time as opposed to locking a mortgage rate too late.

If you've never been on the wrong side of that gamble, just ask a friend -- it stinks.

So, to get help with your rate lock, including timing it for the lowest possible rates in your local market, with your details and I'll do my best to help get you started. I answer all my own emails and my mortgage rates are very good.

If the Fed Funds Rate correlated to 30-year fixed mortgage rates, this chart would be linear. It's not.

This point takes on added significance 8 times annually when the Federal Open Market Committee meets.  The FOMC is the policy-setting ARM of the Federal Reserve.  It raises or lowers the Fed Funds Rate to slow down or speed up the economy, respectively.

The Fed's actions are so important to markets and investors that news organizations like the Wall Street Journal dedicate entire sections to things like "Fed Watching". Comprehensive coverage doesn't make the Fed Funds Rate any less misunderstood, however.

Even the brightest of the bright mistake the role of the FOMC in mortgage markets.

The Federal Reserve does not set mortgage rates. Mortgage rates are based on the raw price of mortgage-backed securities plus applicable loan-level pricing adjustments.  Or, with respect to jumbo mortgages, rates get set by individual banks.

The Fed does, however, influence rates.

Combining rhetoric with more than a trillion dollars, the Fed has helped keep fixed-rate conventional mortgages below 5.500% for the better part of the year.  And now markets are curious: Is the Fed done with its interventions?

The FOMC starts a 2-day meeting today and there's a 1 in a million chance the Fed will raise the Fed Funds Rate from its current range near 0.000 percent.  But that doesn't mean that mortgage rates won't change.  All that has to happen is for the Fed to change it rhetoric.

After its last meeting, the FOMC said the economy is "leveling off". Since then, the housing market has shown tremendous strength and Chairman Ben Bernanke has said the recession "is very likely over".  Therefore, it wouldn't be out of the question for the Fed to get more rosy in its economic outlook and that would cause mortgage rates to rise.

In fact, markets are almost prepping for it.

Today, rates are rising in advance of the FOMC's 2:15 PM ET press release Wednesday.  If you're the nervous type, consider locking in your mortgage rate.  There's a much bigger chance that rates will rise this week than rates will fall.

As a loan officer, I have a direct feed to the mortgage-backed securities market and watch it all day long.  I can help you time the market bottoms to get the best rates possible.  with your loan details and I can watch your rates for you.

Or, fan me up on Facebook -- I post semi-regular market updates to my profile.

Markets move quickly and unless you're watching the data in real-time, you're probably going to pay a higher rate than you have to.  Locking near-bottom requires precision.

The Federal Open Market Committee adjourns from its 2-day meeting today after which the FOMC will issue its customary press release.

The majority of Wall Street expects a Fed Funds Rate cut to 1.000 percent -- the lowest level since June 2004.  Plus, it's worth noting that some are calling for an all-time low -- FFR 0.500.

The Fed Funds Rate is currently 1.500 percent.

Cuts in the Fed Funds Rate are meant to stimulate the U.S. economy and it's the Federal Reserve's primary arrow.  It works because the Fed Funds Rate is the variable component of Prime Rate, as shown below:

As the basis for most consumer loans, Prime Rate is the benchmark interest rate against which credit card, equity line, and construction loan borrowing rates are based. 

As Prime Rate falls, Americans pay fewer interest charges to their banks and lenders, leaving them with additional disposable income each month.  More often than not, these "extra" household dollars find their way back into the economy, spent on things like LED light bulbs, thereby propelling the economy forward.

But another -- and perhaps more important -- way in which a falling Prime Rate helps the economy is that most commercial loans are based on Prime Rate, too, and right now, American businesses are keeping their purse strings tight. 

Inertia is working against capital spending and a dramatic Prime Rate drop may be needed to reverse that path. 

As Prime Rate falls, it brings business borrowing costs with it.  This changes the math of the ever-present "Replace or Repair?" question that dogs managers.  Only uber-cheap borrowing will entice businesses to stop repairing what they've got and start making good-for-the-economy large capital expenditures.

Think of it like having a jalopy.

If you can get 0% APR financing for a new automobile, you're more likely to buy one than if you had to pay 4.9% annually to finance one.  If the money is going to cost you 4.9%, you may just opt for small repairs until the car, literally, falls apart.  In lowering the Fed Funds Rate, the FOMC hopes to grease the nation's spending wheels.

Ironically, it may end up doing too good of job.

Because it takes 9 months for a Fed Funds Rate cut to fully work its way through economy, the United States is only now digesting the January 2008 rate cut to 3.500 percent. 

When the January rate cut happened, we warned of the Fool in the Shower theory -- the Federal Reserve's tendency to accidentally overheat the U.S. economy.  And, with each successive rate cut, that likelihood grows.

An overheated economy can be as bad for the U.S. as a frozen one but it looks like the Federal Reserve will want to deal with that when it happens.  For now, the focus is on thawing the credit market and finding economic balance.

The chart above doesn't go all the way back, but since 1990, the Fed Funds Rate has moved in quarter-percent increments only. 

This is a big deal because the Federal Reserve meets next week and there is a bevy of discussion among market players about whether the Fed should raise the Fed Funds Rate by 0.250% to fight inflation, or hold the FFR steady to support ailing banks. 

Pundits are split between the two scenarios:

• Some think a quarter-percent hike would devastate the economy
• Some think a quarter-percent hike would heal the economy

There is a third option, though, and it exists somewhere in between the two. 

Instead of moving in 25 basis point increments, the Federal Reserve could get more specific.  Increase the Fed Funds Rate by something like 8 basis points.  A precise adjustment like that could yield a precise impact on the economy.

Here's another way to look at it:

Read the rest of this entry »

The Federal Reserve is expected to lower the Fed Funds Rate Tuesday and that should cause mortgage rates to move higher.

This is a counter-intuitive relationship for most people because when they hear that the Fed is "lowering rates", they instinctively think it means "mortgage rates". 

That's not the case at all; the Fed Funds Rate has very little to do with mortgage rates.

If the Fed Funds Rate and mortgage rates were truly related, the chart shown here wouldn't diverge towards the right -- all three lines would move in tandem. 

And they don't. 

The Fed Funds Rate is an interest rate usually reserved for loans from one bank to another, beginning at the close of the business day and repaid the following morning before the start of the next business day.

This is why the Fed Funds Rate is often called an "overnight rate"  -- the money is literally borrowed overnight.

By contrast, mortgage money is typically borrowed over 30 years.  This is 10,957 overnight rates strung together and is a completely different risk class altogether.

Fed Funds Rate cuts make mortgage rates go up the cuts aim to spur economic growth and economic growth can eventually lead to inflation -- the enemy of mortgage rates.

When inflation is present, mortgage rates tend to rise so the more inflation there is, the more mortgage rates will PoP! over time.

Now, for the Fed to simultaneously cut the Fed Funds Rate and guide mortgage rates lower, it would have to gently stimulate the economy and not over-stimulate the economy.

That's a huge challenge because Fed Funds Rate stimulus takes up to 12 months to work through the economy and during that year, the Fed would meet eight more times. 

So, at one meeting, the Fed would cut the Fed Funds Rate and then use the seven remaining meetings to see how it all turns out.

The Fed doesn't act like that, however, and explicitly said it doesn't care about long-term inflation risks right now.  The major concern is the short-term and to lessen those risks, additional rates cut are in order.

Therefore, markets are now inferring that the Fed will drop the Fed Funds Rate as far as it has to in order to stop a U.S. recession.  Markets fear the Fool in the Shower scenario that is now looking inevitable -- economic over-stimulation and long-term, runaway inflation. 

It's a terrible outcome for mortgage markets and why cuts to the Fed Funds Rate this week should cause mortgage rates to rise.

Changes to the Fed Funds Rate figuratively literally takes months to work their way through the economy.  That's one reason why the Federal Reserve is in a difficult position today.

After cutting the Fed Funds Rate by 1.750% over the last four months, the FOMC is expected to cut the benchmark lending rate again today.  This would occur despite the fact that Fed has yet to see the cumulative effect of its policy changes. 

There's a very real chance that today's additional rate cut will (someday) push the economy into a rapid expansion characterized by runaway inflation.

There are two main reasons why may happen:

1. The Federal Reseve can't tell where the economy "is" except in hindsight
2. Markets don't react to change overnight

In other words, by the time the Fed recognizes that the economy is expanding too quickly, the expansion is already well under way.  It's hard to stop a train that's moving at full speed. 

In economics, this challenge is called "recognition lag".  It says that policy makers can't immediately identify our current market because economic data is historical, not predictive.

To matters more challenging, when the Federal Reserve makes a cut to the Fed Funds Rate (Point A), the change is not felt by the economy straight away; it takes some times for the economy to adjust to new market conditions. 

We call this condition "response lag" and, during the response lag period, the Federal Reserve will meet several more times.  Even while it's dealing with the response lag.

Despite the uncertainty, the voting members of the Fed usually choose to implement additional policy changes (Points B and C) to stimulate the economy.  These aren't immediately reverberated through the economy, either.

So, by the time the Fed Funds Rate cuts are felt, they tend to magnify the natural economic recovery of the nation.

On the chart this is represented by Point E¹, Point F¹.  Instead of a "normal" path, you can see that the curve follows a new growth curve that exaggerates the upcoming business cycle.

Economist Milton Friedman referred to this scenario as the "fool in the shower".  And it goes a little something like this.

When the fools turns on the shower, the water is very cold.  So, he turns on the hot water.  Only the hot water doesn't come on right away so he turns it on full blast.

Before long, the water gets very hot, very fast and scalds him.  Reflexively, he dials back the heat only to find that he's too cold again.

If you've ever taken a shower, you know what Uncle Miltie meant.

Fed Funds Rate cuts are meant to stimulate growth, it could be at least 12 more months before we'll find out if the recent slashing actually worked.  And yet, today, at 2:15 P.M. ET, the Federal Reserve Open Market Committee is expected to lower the Fed Funds Rate for the fifth time in four months again.

With another broad cut, the Federal Reserve may epitomize Friedman's "Fool in the Shower".  And lead us into runaway inflation.

In a surprise move yesterday, the Federal Reserve cut the benchmark Fed Funds Rate by three-quarters of a percent.  Mortgage rates fell only slightly as the surprise quickly wore off.

To understand how the element of surprise works in mortgage markets, think about a Jack-in-the-Box. 

Everybody knows that the clown is coming, they just don't know how many turns of the crank it will take.  When it pops out, there's an immediate shock.  Then it's back to business.

This simplified analogy is similar to what happened yesterday, post-rate cut.  It's why many people that expected rates to fall further were dissappointed.

The bigger reason why mortgage rates don't fall when the Federal Reserve cuts the Fed Funds Rate is because Federal Reserve does not control mortgage rates; it controls the Fed Funds Rate. 

Mortgage rates are based on the prices of 30-year instruments called mortgage bonds; the Fed Funds Rate is an overnight interest rate.  Both, however, tend to fall during periods of economic weakness. 

• The Fed Funds Rate falls to stimulate the economy
• Mortgage rates fall because inflation is less threatening

Prior to yesterday's surprise cut, market expectations for the FOMC's two-day meeting were:

• 42% expected a 0.500% drop, representing moderate weakness in the economy 
• 38% expected a 0.750% drop, representing strong weakness in the economy 
• 18% expected a 1.000% drop, representing very strong weakness in the economy

So, any mortgage rate movement from yesterday was the people in the 0.500% camp moving their portfolios down to 0.750%, and the people in the 1.000% camp moving their portfolios up.

Remember: mortgage markets are "open" every day whereas the Fed meets just eight times annually.  This gives the markets a ton of time to intrepret news, listen to Fed speakers, and generally prepare for the next Federal Reserve meeting. 

And many were already prepared -- even if it came a few days early.

The big winners yesterday were people with home equity lines of credit, and those that carry credit card balances.  Effective January 22, 2008, your borrowing rates just fell 0.750%.

Prime Rate is now 6.500%.

In June 2004, the Federal Reserve started a string of 17 consecutive rates hikes that lifted the Fed Funds Rate to 5.250%.  This caused Prime Rate to rise, too, because Prime Rate is always three percentage points higher than the FFR.

In mathematical terms, it looks like this:

(Prime Rate) = (Fed Funds Rate) + (3.000)

The Fed Funds Rate itself doesn't have much importance to everyday Americans because it's an interest rate used chiefly in bank circles.

Read the rest of this entry »

I am not in the game of making predictions about mortgage rates because I don't gamble with other people's money.  This is the major reason why I recommend locking at today's mortgage rates rather than waiting for tomorrow's.  Who knows what tomorrow will bring?

After all, think back 25 years:  Investors were passing on 17% yielding bonds because they wanted to wait for 18%.  In hindsight, it's a foolish risk.

But, everybody likes to ask me what I think anyway.  So, here you go:  This Armchair Quarterback says that no matter what the Fed does today, it's going to be bad for mortgage rates.

If the Fed lowers the FFR, looser credit should boost the stock market, causing dollars to flow into stocks at the expense of bonds.  The decreased demand for mortgage bonds pushes mortgage rates higher.

If the Fed holds the FFR, it's a signal that the Fed is more concerned about inflation than the effects of the credit markets and that should cause the dollar to weaken dramatically.  This will cause mortgage bonds to devalue and that would push mortgage rates higher.

If the Fed raises the FFR, well, as four exterminators would put it: think fire and brimstone coming down from the skies, rivers and seas boiling, forty years of darkness, earthquakes, volcanoes, the dead rising from the grave, human sacrifice, cats and dogs living together -- mass hysteria.  And that would have to be bad for rates, somehow, I would think.

I just don't see a winning scenario for mortgage rate shoppers today.

The FOMC releases its statement at 2:15 P.M. ET.

With just a few days remaining until the Federal Reserve's next meeting, the guesses about what moves the Fed will make next are becoming more clear.

Two weeks ago, there was a 70% chance that the Fed would stand pat at 4.750%.  At that time, I was questioning whether a HELOC or HELOAN was the better option.

Then, a steady stream of less-than-positive news about the economy started, coupled with missed earnings and negative sentiment from Wall Street. 

Throw in a few public speeches from Fed memebers and technical trading factors like 200-day moving averages and you start to understand why that 70% confidence level is now just five percent.

Today, markets expect with 95% certainty that the Fed will lower the Fed Funds Rate October 31 after its two-day meeting concludes. 

This is good news for holders of Home Equity Lines of Credit, but may be bad news for mortgage rate shoppers; the last time the Fed lowered the Fed Funds Rate, mortgage rates spiked on a weakened dollar and recession fears.

HELOC or HELOAN?  Today, I am little more sure.  The answer is HELOC.

(Image courtesy: Federal Reserve Bank of Cleveland)

The Fed may have lowered the Fed Funds Rate by 0.500%, but we won't know until mid-2008 if the move was good one or not. 

It's because the FOMC voting members walk a fine line between accelerating the economy, and grinding it to a halt. 

Predicting the future is actually a subtle part of the job description at the Fed because changes to the Federal Funds Rate create a complex chain reaction in the economy, beginning with businesses and their planning, spending and pricing decisions. 

Then, when those changes are fully-implemented, the changes trickle down to consumers who respond in kind with their own planning and spending decisions.

Because consumer spending makes up the bulk of our nation's economy, you can see why it takes nearly three seasons for Fed Funds Rate changes to permeate the economy in full.

If you don't think members of the Fed have tough jobs, you may be crazier than this guy.

The Fed's job of managing the Fed Funds Rate is like shooting free throws outside on a windy day.  The wind causes conditions to change routinely and makes the shot extra difficult. 

But to add a twist, the Fed has to wait nine months to figure out if the last shot it took actually went in.  If the Fed's shot last week "missed", we won't find out until next spring when all of the inflation data has come to light.

We can't wait that long, though.  The Fed will meet five more times before next spring -- before we know if the 0.500% cut was effective.  The Fed can't know if the last shot it took was off the mark before having to take its next shot. 

Ouch.

The impact of the Fed's rate cut won't be known until next spring -- too late to help out with the Fed meetings this fall and winter.  So, if you're wondering why the Fed tends to follow a string of rate hikes with a rate drop, and vice versa, this is it.  That final adjustment helps the Fed "pull-back" making over-adjusting in a changing economy.

It's been slow going getting back in the saddle after last week's trip.  A hearty "thank you" to my team at the office that made it all happen while Greg and I were away.

Although markets appear calm right now, we're sitting in the eye of a storm. 

The Federal Open Market Committee meets for the first time since early-August and since that date, it's been a series of disappointments about the economy, housing, and consumer sentiment. 

Global markets are on notice that U.S. housing issues may be spilling over into other parts of the economy and there hasn't been a day that goes by without some form of speculation about what the Fed will do at today's meeting.

One week ago, I cited a 28 percent chance of the FFR dropping to 5.00%, and a 12 percent change of it staying at 5.250%.  Today, those probabilities are 44 percent and 2 percent, respectively. The chance of a 50 basis points drop to 4.750% remains at about 45 percent.

I say, forget the stats, people.  Just read this: No matter what happens this afternoon, 40 percent of the market will have made a "bad bet" and those players will have to change their bet as soon as they find out that they were wrong. 

That's a lot of traders scrambling for new positions and when those bets change, mortgage rates will run in one direction or the other.  We just don't know in which direction yet and we won't until 2:15 P.M. ET.

Better safe than sorry, I say.  Get in and get locked this morning if you are floating your mortgage rate.  There's just too much risk out there right now.

August 13, I was talking about my favorite Greek Yoghurt and how it related to mortgage rates.  Yes, I spelled it "yoghurt".  That's because I am paying homage to the beautiful city of Dublin.  It was even sunny for a few minutes this morning.

But I digress.

August 13 is sort of significant for other reasons.  On August 13, markets were pretty certain that the Fed was going to hold the Fed Funds Rate at 5.250% at its next meeting.

Then, on August 16, Countrywide went public with its credit problems.  Next, on August 17, the Fed cut its discount rate by 50 basis points to help promote liquidity among banks. 

That's when speculation grew in earnest about a looming Fed Funds Rate cut at the September 18 meeting.

According to the graph above from the Cleveland Federal Reserve, the probability of the Fed leaving the FFR unchanged August 13 was pegged at 55 percent.  This past Friday -- in the wake of the jobs report -- that probability dropped to three percent. 

Meanwhile, the odds of a 50 bps decrease down to 4.750% followed the exact opposite pattern.  Follow the yellow and blue coloured lines to see what I mean.  And yes, more homage to Ireland and its fanciful spelling.

If you're wondering why mortgage rates have improved lately over the last 28 days, the graphic is terrific place to start finding answers.  The bigger the expected drop in FFR, the lower mortgage rates should go.  To market participants, a drop in the FFR is a signal of slowdown, or even worse, a recession.  Both of those scenarios tend to drop mortgage rates.

At this point, though, the market's expectations have changed so fast that we're likely sitting in an "over-bought" pattern.  Even if the Fed does drop the 50 basis points that markets are expecting, it's likely mortgage rates will bounce higher on the news; there are just too many folks that are betting on seventy-five basis points or more.

I interviewed with First Business anchor Anchor Beejal Patel this week.  First Business produces news "shorts" that are syndicated nationwide. 

The story: "How would a Fed rate cut impact mortgage rates?"  You all know my answer -- it's well-documented around these parts.

I am a little embarrassed about having to use somebody else's office for the spot, though; you'll notice the photo of his three kids and one of their rainbow drawings over my left shoulder.

The rainbow does complement my tie nicely, though...

I have fielded three separate questions from clients on the topic so that must mean it's time to address the issue in public.

The Fed does not control mortgage rates.  The Fed controls the Fed Funds Rate.

The chart above from HSH Associates shows the path of the Fed Funds Rate (in brown) against a few mortgage products since June 2004.  If there was a direct connection between FFR and mortgage rates, the chart wouldn't show the brown line playing catch-up.

The Fed Funds Rate is a short-term interest rate and its function is to make money more costly to borrow or less costly to borrow for homeowners and business owners.  This works because many bank loans are based on Prime Rate (which is 3.000% higher than the FFR).

As FFR goes up, so does Prime Rate.  And, as Prime Rate goes up, so does the cost of borrowing money.  The reverse is true, too, if FFR drops. 

Nowhere, you'll notice, do we mention mortgage rates in connection with the Fed Funds Rate.  That's because mortgage rates are based on the mortgage-backed securities market -- a global exchange similar to the NYSE or NASDAQ.  The Fed doesn't operate in these markets.

Mortgage-backed bonds are considered long-term products and pricing is based on long-term expectations of the U.S. economy and the U.S. dollar. 

The graph above shows how the market's expectation of the Fed have changed since March. 

• The colored lines represent the Fed Funds Rate as set at the FOMC's August meeting.
• The x-axis represents time
• The y-axis represents the percent likelihood of an event happening

So, moving from left-to-right, we can see how the markets gamble on the Fed Funds Rate.

On March 13, there was an equal probability -- 30 percent -- that August's Fed Funds Rate would be the same today (5.250%) as that it would drop to 5.000%. 

As of last Wednesday, markets predict with 95% certainty that the rate will be remain unchanged with just a 2% chance that it will drop.  Today's unexpectedly strong employment data should push that spread even wider.

Quick Primer: The Fed Does Not Control Mortgage Rates but it does swing a big stick in mortgage markets.  The Fed tries to stem runaway inflation and inflation is the enemy of mortgage bonds.

So, when the Fed Funds Rate increases, it sends signals to mortgage bond markets and that is what move mortgage rates.  Right now, the expectation of the FFR increasing is impacting markets more than the actual action itself (which hasn't happened, of course).

(Image Courtesy: Federal Reserve Bank of Cleveland)

According to the GDP data released this morning, economic growth is slowing.

Normally, slowing growth would be fantastic news for mortgage rate shoppers, because slowing growth tends to lead to lower mortgage rates.

Today, however, that's not the case because employment is strong, cost of living indicators are high, and the Fed is worried about inflation.  Inflation, you'll remember, is when the value of the dollar decreases and more dollars are needed to buy everyday items. 

A weaker dollar does more to raise mortgage rates for homeowners than an economic slowdown does to lower them.  It's not very common to see both conditions exist simultaneously.

As the inflation-and-growth controlling arm of the government, the Fed may now find itself in a bind with respect to setting the Fed Funds Rate going forward. 

See, the Fed can't raise the FFR to stave off inflation, nor can it lower the FFR to stoke growth.  Therefore, the Fed is somewhat resigned to sitting back and just waiting to see what comes down the river.

San Francisco Fed President Janet Yellen acknowledged this dilemma yesterday, stating that the Fed is most likely to enter a "watchful waiting" mode before deciding to raise or lower rates. 

This comment surprised markets which expected the Fed to begin cutting the FFR as soon as this summer.  Mortgage rates moved higher in response.

Ben Bernanke told the congressionals Joint Economic Committee that inflation is "somewhat elevated", but it's no reason to expect a rate hike.

In his prepared statement, Bernanke said a lot of things, broken down as follows:

• Economic growth has slowed because of a "substantial correction" in the housing market
• Sub-prime industry problems are self-contained (so far)
• Business spending will pick up this year
• Consumer spending will propel the economy forward
• Inflation is down largely because of energy costs are down

The Fed sets the Fed Funds Rate for the United States and, typically, as FFR increases, the rate at which the economy slows down increases, too.

But, the Fed also has a "secret weapon" to slow down the economy -- worms words.

Every time a Fed official speaks in public, there are countless people dissecting every sentence, phrase and nuance, trying to plan their next move for business or investment.  In this respect, the Fed can creates expectations in the market and that can slow down (or speed up) inflation without technically "doing" anything.

Today's testimony is relatively neutral news for mortgage shoppers -- mortgage rates are unchanged on the day because most of what Chairman Bernanke discussed was already known and priced into mortgage rates.