Thanks for visiting The Mortgage Reports. To stay absolutely current on mortgage markets and important guideline changes, be sure to take my free daily email alerts.

Mortgage rates are notoriously volatile when the Federal Open Market Committee meets and today is such a day.  Today's meeting is one of  this year.

The Federal Open Market Committee is a rotating, 12-member sub-group within the Federal Reserve that debates about financial and economic conditions around the county, and votes on new policies meant to spur, steady, or slow economic growth.

The FOMC's economic toolbox is big, filled with programs and policies that most laypersons have never heard of, or even thought of.  The group's most well-known tool, though, also happens to be its most wielded -- the Federal Funds Rate.

The Fed Funds Rate is the rate at which banks borrow from each other overnight.  The lower the rate, the less banks pay in interest costs, and the more money is available for lending. 

It's in this way that the Fed Funds Rate impacts the economy.  When it's down, banks tend to lend more money, giving the economy room to grow.  And, conversely, when it's up, banks tend to lend less, constricting economic expansion.  This is one reason why FOMC meetings are such big news -- the Federal Reserve has a direct impact on the future of the U.S. economy.

The FOMC is expected with 100% certainty to vote the Fed Funds Rate unchanged from its current 0.000-0.250% target range at today's meeting.  Therefore, it won't be what the FOMC does that matters to mortgage rates. It will be what the FOMC says.

With the economy flopping between growth and recession, and with the Fed pledging to keep the Fed Funds Rate low for as long as necessary, markets will break down the FOMC press release for clues about what's in store economically for late-2009 and 2010.  As one example, if inflation is singled out as a threat, mortgage rates should rise because inflation erodes the value of mortgage bond repayments.

Given the current environment of low mortgage rates -- whether you live in Hyde Park, Cincinnati or Hyde Park, Chicago -- there's definitely more chance of mortgage rates rising this afternoon than falling.  There's only so much lower rates can go, you have to believe.

The Fed's press release hits the wires at 2:15 PM ET today.  If you're the cautious type, consider locking your rate prior to the release.

When the Federal Reserve lowers the Fed Funds Rate, mortgage rates tend to increase, and it's always for the same, few, related reasons:

1. Rate cuts create long-term inflation pressures
2. Rate cuts makes the U.S. dollar get weaker
3. Rate cuts reflect short-term economic weakness

But rate cuts are just one way that the Federal Reserve can impact mortgage rates; there's more than one color in the Fed's crayon box, after all.

Read the rest of this entry »

I'm not a huge reader of USA Today, but I happen to be at hotel on Long Island this morning and McPaper showed up at my door this morning.

Surprising to me, there are a few interesting stories in the Money section.  So, as we usually do, let's relate them to mortgage rates.

World events work against grain buyers
Bad weather and surging global demand has created the tightest grain stock in 30 years.  Wheat prices are skyrocketing food companies have a choice -- absorb the costs, or pass them on to consumer?  Either way, mortgage rates should benefit because less dollars are being spent on capital and/or consumer goods.  A slowing economy retards inflation.

Fed chief's outlook: 'Uncertain'
Ben Bernanke says that housing is likely to be a significant drag on the economy through early 2008, and that conditions in financial markets have improved since "the worst of the storm" in mid-August.  Half of Bernanke's job is to help keep markets calm so this speech may have been a giant preview for the October 30-31 FOMC meeting. 

Oil surges to record, but gas prices don't follow suit
As with wheat prices, it's only a matter of time before producers pass on rising costs to consumers.  One major storm or cold spell and prices could rise not only at the pump, but in our homes as well.  This normally pushes mortgage rates lower because higher costs forces disposable income to drop, thereby slowing the economy.

Justin Timberlake and Scott Wolf dine at Mawat; Unaware of Mortgage Planner Dan Green
Okay, this story didn't show up in USA Today, but it happened.  I wondered why it took nine waiters to serve that table next to me until I looked over.  Neither was impressed with my new haircut.

That's all, folks.  Bring it on in to Omeletteville.

It's easy to play Monday Morning Quarterback from my laptop, but now that we've seen most of September's data, it looks like the economy is not as weak as was advertised.

• Jobs data was revised higher
• Retail sales blew away expectations
• PPI was off the charts
• Jobless claims continue to trend downward

Fear shaped market expectations this summer and most of it stemmed from the crumbling sub-prime market. In time, though, as markets always do, that fear got turned into a price, markets found a sense of balance, and life goes on.

This is the way of the credit markets.

Well, now the data on which the fears were based is available, it seems that there really wasn't a monster at the end of this book.  The economy appears to be strong, resilient, and expanding -- three sentiments the Fed failed to pick up when it met in September to lower the Fed Funds Rate by 0.500%.

As of this morning, markets can only guess if the Fed dropped rates too soon.  But, if next week's data on September continues the trend of expansion and growth, expect extreme mortgage rate volatility leading up to the Fed's two-day meeting October 30-31.

The Fed's September meeting minutes were released yesterday and revealed a few interesting points:

• The Fed anticipated that the August Non-Farm Payroll report would be revised higher
• The Fed make a specific point to not say that recession pressures are outweighing inflationary ones
• Some of the Fed's non-voting members are seriously concerned about inflation

The Fed minutes show that the Federal Reserve lowered the Fed Funds Rate to 4.750% because there was an inordinate amount of uncertainty in credit markets. 

Voting members were concerned that if they did nothing, the problems would only get much worse.

How much worse? Well, when access to credit goes hasta la vista, the entire world economy can freeze. 

Imagine if all of your credit cards and credit applications were effectively shut off, limited, or outright refused.  The Fed was trying to be prudent, it appears.  Better to do too much than too little, it reasoned.

Mortgage rates were flat after yesterday's release of September's notes because there's no clear direction as to what the Fed will do at its next meeting, October 30-31. 

For those that like to speculate, though: If the Fed lowers the FFR again later this month, expect mortgage rates to increase.  If the Fed holds steady or increases FFR, expect rates to fall.

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.

I fielded a lot of phone calls yesterday from my clients about the Fed lowering the Fed Funds Rate and how it impacts them personally.  I love days like those -- it shows me that my clients are paying attention to the financial world and how it impacts them.

Education is the benchmark of my practice and I really enjoy talking to everyone, helping them relate the news to their lives.

See, in all of the talk about the Fed Funds Rate, specific numbers tend to get left out of the article in the newspapers and from the graphics on the TV.  That's why I built the graph above.

The Fed Funds Rate has little impact on the everyday lives of people like us because its an interest rate that banks use in lending to each other.  Think of it like an interest rate "among friends" -- a little bit lower than what you'd charge someone else, but still high enough to get compensated.

Now, there's a little trick here.  The "someone else" are consumers like me and you.  When they're lending to us, the banks tack on three percentage points and they call that new interest rate "Prime Rate". 

This is why Prime Rate is always 3.000% higher than the Fed Funds Rate.

Therefore, because the Fed Funds Rate is now 4.750%, Prime Rate is now 7.750%.

That small detail is a pretty big deal because banks tend to use Prime Rate as a starting point for consumer loans.

• Home equity lines of credit may be Prime + 0.500%
• Credit card loans may be Prime + 8.999%
• Auto loans may be Prime + 2.000%

Here's where it gets interesting for the everyday American. 

According to the L.A. Times, consumer debt in the United States (not including mortgages) is $2,456,000,000.  Chop 1/2 percent from that and Americans are saving $1.228 billion in interest every single month because of what the Fed did.

Now, for people that don't carry consumer debt, the impact is likely to be small.  But many people hold balances on their credit cards, or have not paid down a HELOC.  Starting Tuesday afternoon, the rates on those debts dropped.

Prime Rate was 4.000% in June 2004 before the Federal Reserve started a string of 17 rate hikes to 8.250%.  Tuesday's drop is the first reversal since the rate hikes began.

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.

In its press release yesterday, did the Fed intentionally ignore the impact of credit markets in order to prevent a full-blown financial panic?

According to the text, Bernanke & Co. are still watching inflation intently and its long-term economic view precludes it from acting upon last week's drastic credit crunch.

And, in the wake of the Fed's statement, pundits are in agreement that the Fed seems unconcerned about credit market deterioration.  They also note that the Fed is sending a signal of confidence about the U.S. economy on the whole.

I buy that like of thinking, I do.  But, I also remember back to some prior posts I've written.

Eight months ago, I listened to Federal Reserve President Michael Moskow speak about inflation at a breakfast in Chicago.

Paraphrased, he said:

Inflation is a self-fulfilling prophecy -- if you behave like it will happen, you will actually make it happen. Therefore, part of the Fed's role is to make pre-emptive policy changes to shape market psychology.

I wondered aloud at the time if the Fed stopped raising the FFR last summer just to head-fake the markets into believing that inflationary pressures were taming.  After the non-hike (and not surpringly), inflation began to slow shortly thereafter.

Now, I am wondering the opposite.  Is the Fed using psychology to keep the economy strong?

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)

And the hits just keep on coming. 

The Fed's May meeting minutes showed that it is concerned about inflation and that is pushing mortgage rates higher once again today.

Despite "more favorable" economic readings, inflation remained "uncomfortably high" for the Fed and is following neither a downward trend, nor an upward trend. 

This makes it less likely that the Fed will lower the Fed Funds Rate rate in the near future.

The Fed's inflationary discomfort is forcing markets to change their expectations once again.  As we've discussed 56 times before, of course, the expectation in markets is more important than the news itself.

See, for the last 12 months, the experts keep calling for an economic slowdown.  Unfortunately, reviewing economic activity is a study of the past.  Making money off the markets is a prediction of the future.

You can see where the problem lies, right?  The best way for traders to make money in financial markets is to properly predict how some "thing" will perform over time. 

Their expectation drives their investment.

If the expectation is for inflation (the enemy of bonds), traders will dump their mortgage bond holdings and that forces mortgage rates higher.  It's not because inflation happened, it's because inflation is expected to happen.

Now that the Fed publicly stated its concern about inflation, expect data related to overall growth, cost of living and dollar-trading to move to center-stage.  Housing data will take a back seat (for now).

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.

The Federal Open Market Committee just made a press release following their two-day meeting.  The text can be read at the Federal Reserve Web site.

I will provide some additional reading material from the WSJ shortly (because I love their "Parsing the Fed" series).  For now, the key verbiage in the statement is below:

Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market. Overall, the economy seems likely to expand at a moderate pace over coming quarters.

In other words, housing's "stabilization" isn't expected to lead to runaway economic growth.

Markets like this news and are retreating a bit off their highest levels since October.

In one of my favorite posts ever, I wrote about the time Chicago Fed President Michael Moskow addressed the topic of inflation with a room of Chicago businesspeople.

Paraphrasing, Moskow made the following points:

1. There is a direct link between the expectation of inflation and actual inflation
2. Because they prepare for inflation, businesses actually make inflation happen
3. One function of the FOMC is to manage business' expectation of inflation

Summarized: Inflation is a self-fulfilling prophecy and the FOMC uses its words and the Fed Funds Rate to fight predictions. 

Stated differently: The FOMC responds to market psychology as well as data. 

That's a strange and frightening thought.  Economists are not psychiatrists.  We alluded to this game last September in a post titled "Did the Fed fake out the markets in an attempt to slow down the economy?" and the concept has not warmed on us one bit.

Today, the FOMC begins their two-day affair and you can be sure that managing business' prevailing inflation anxiety is high on the meeting agenda. 

In their last post-meeting press releases, the FOMC stated that housing weakness should drag down growth by about a full percent.  Yet, housing has shown resiliency and has some pundits even calling for a <gasp!> rebound. 

If housing bounces back, businesses know that the "1% drag" on growth will never happen and that puts inflation back in play.  Back to the self-fulfilling prophecy bit: this is a major contributor to the huge run-up in mortgage rates lately; markets are preparing for inflation.

Tomorrow afternoon, the FOMC will issue a press release summarizing its meeting.  The questions remains, though: Will the press release be issued from behind the desk, or from the fluffy couch?

If you ever want to bore everyone you know, start talking about the Federal Open Market Committee and monetary policy.

I know this from experience.  I may not be invited back to Thanksgiving next year.

But, tomorrow morning, you will read the headlines on the front page of your local newspaper:  Fed Leaves Rates Unchanged.

It's important to understand how the Fed's decision to hold the Fed Funds Rate at 5.250% impacts mortgage rates and the answer may surprise you -- there is no relationship at all.

The Fed Funds Rate is a short-term interest rate and it's premier implication to the economy is that it makes borrowing money from banks more expensive.  Prime Rate is based on the Fed Funds Rate and is always 3 percentage points higher than the central bank's benchmark rate.

Business owners and homeowners are familiar with Prime Rate -- it's the rate upon which credit lines and home equity lines of credit are based.  As the FFR increases, so does Prime Rate, and by association, so does the cost of short-term borrowing in our country.

Mortgage rates, on the other hand, are determined by the mortgage-backed securities market and most of these bonds are 30 years in duration, whether they are fixed rate, or adjustable in nature.  Mortgage-backed bonds are considered long-term products.

Short-term versus long-term.  Two totally different markets.

Have I bored you yet?

If so, let me jazz this up with the graphic from HSH Associates aboce.  The graph shows that -- over the last three years -- as the Fed Funds Rate has increased, the 30 Year Fixed Rate Mortgage has remained relatively flat.

There is no direct link, in other words.

Long-term rates are governed by the overall health of the economy, and the expectations of future growth.

For this reason, what the Fed said today is much more important than what they did (or didn't do).

The Fed's press release discusses their position on inflation, on housing, and on the growth of the United States economy.  Because the Fed slightly shifted the long-term expectations of the economy to the "slow" side, long-term securities (including mortgage bonds) are coming down in yield (i.e. rate).

Flash back to June 30, 2004.  The Fed Funds Rate was 1.000%.

June 30, 2004 was the date of the first of 17 consecutive increases to the Fed Fund Rate.  At the time, the 10-year treasury note was yielding 4.59%.

Today, with the FFR standing at 5.250%, the 10-year treasury is yielding 4.42% -- a drop of 17 basis points.

The FFR is the ultimate short-term interest rate; it's the cost to borrow money overnight, risk-free between banks.  The 10-year treasury, on the other hand, is longer-term.  In fact, it's like 10 consecutive years of overnight rates.  It's also considered to be risk-free.

Because the 10-year note is lower than the overnight rate, we can infer that markets believe the cost of overnight money will decrease over time, averaging 4.42% over 10 years.

Markets are already predicting with 60% probability that the FFR will be lower in March 2007 than it is today.

In a prepared speech yesterday, Fed Chairman Ben Bernanke said that inflation was "uncomfortably high" and remains a major concern for the Fed.

Over the past few weeks, the Fed has consistently said that it expects economic growth over the next year to fall in the 1-2% range, down about 1% from the current conditions.  The Fed has reiterated time and time over that housing will lead the cooldown as the (anti-)Wealth Effect curbs consumer spending.

However, Bernanke specifically remarked that the slowing housing market has not yet slowed down other industries, as had been anticipated.  Remember back to the Fed's last press release in which they wrote that a "cooling of the housing market" slowed economic growth.

If housing is not spilling over to the rest of the economy, the Fed may not get the slowdown they planned for.  And, if the Fed no longer believes that housing will create a 1% drop in growth, we need to all be prepared and adjust our expectations of inflation.

Bernanke fired the first warning shot and he did it in plain English.  Strangely, the market's reaction was muted.  Mortgage rates held steady.

Source
Fed Chief Optimistic of Soft Landing
Nell Henderson
Washington Post, November 29, 2006
http://www.washingtonpost.com/wp-dyn/content/article/2006/11/28/AR2006112800635.html

Parsing the Fed
Wall Street Journal Online, October 25, 2006
http://online.wsj.com/public/resources/documents/info-fedparse0610.html

Tomorrow morning, the Non-Farm Payrolls report is due and the markets are in upheaval erev-First Friday. 

The traders are having a real heck of time determining whether we're in the middle of an economic expansion, or an economic depression.

The talking heads are out in full force, discounting the value of Non-Farm Payrolls in light of Hurricane Katrina and Hurricane Rita; and in the face of plummeting oil prices; and with respect to contradictory economic data released week after week.

And yet, the Fed constantly telegraphs that it will continue raising the Fed Funds Rate.  This is a signal that the market is in the midst of an expansion, and showing signs of stronger-than-expected inflation. 

If the Fed is focused on slowing growth using increases to the Fed Funds Rate, we should all take note and react accordingly. 

For every Warren Buffett whose every stock purchase moves markets, there are literally hundreds of private traders who read their own charts, devise their own formulas, conduct their own research, and make millions on their exceptional informational advantage.

These are the best traders in the world and you and I never hear about them because they don't sell their systems to the public on Bloomberg or whatever.  It is far more profitable for them to keep their informational advantage a secret. 

But! There is one group that actively shares its research and encourages traders to apply its findings. That group, of course, is the Federal Open Market Committee.

The FOMC as a group has two major advantages over every market participant:

1. It gets access and published more information than an individual trader can
2. It can change the game (i.e. our nation's monetary policy) if conditions warrant it

So, as bonds get whipsawed this week, we can conclude that traders chose to ignore the Fed's stance that inflation is present and now they've found themselves in a poorly-planned long position.

The Fed is reiterating that it will raise the Fed Funds Rate as needed -- just as it has for the past 18 months -- and, yet, market participants suddenly looked surprised.

When Non-Farm Payrolls misses expectation tomorrow morning, don't knee-jerk and try to win on the news.  The smartest market player has already shared the near-term economic projections with you -- strong, healthy, and expansive.