Vail Daily column: Will mortgage rates rise if the Fed increases other rates? | VailDaily.com

Vail Daily column: Will mortgage rates rise if the Fed increases other rates?

One of the little understood facets of our economy is the role the Federal Reserve Bank plays in controlling interest rates. Make no mistake, it is a major influence, but there is no secret button the Fed can push to fully control rates, and in many cases throughout the years the Fed has found its actions have the opposite impact of what it intended.

What the Fed primarily does is act as a lender to banks to cover short term cash needs. This allows the banks to keep their money working elsewhere while meeting demands of depositors who just have got to go on a vacation or buy a new flat screen and want to make a pesky withdrawal from their accounts or hit their credit cards. These are called overnight loans, and member banks can borrower as needed (within reason). Banks can also borrow for longer periods of time to even out their cash flow.

If the Fed decides consumers and businesses need to spend more, then they encourage that by loosening up how much a bank might borrow and at what terms. This encourages the banks to lower rates to consumers and lend more readily. At least in theory that is what is supposed to happen.

The problem is that some banks did the math the last several years and figured out that they could borrow from the Fed for next to nothing and turn around and invest it in treasury bills (which pay slightly more than next to nothing) and pocket the difference with neat zero risk versus lending it to those foolish consumers who wanted to buy cars, boats and flat screens.

As a result, the Feds’ actions were muted considerably because the generosity of loaning money to banks for near zero was not passed onto the taxpayers whose money was being lent out to begin with.

We may be reaching a tipping point in the economy where the Fed will decide to cool things off a bit and start raising rates. In theory, this will tighten credit and raise rates on home loans, car loans and the like and cool off the pressure of consumers buying more than producers produce and pushing up prices.

Complex Issue

But history indicates another outcome is entirely possible, and if the Fed doesn’t weigh this into their deliberations I would suggest the Fed board of governors is blinded by the glare from the Capitol dome and should back off and reconsider. But I will admit it is a very complex issue and there are some arguments to the contrary of mine.

In the past when mortgage rates were too high, we prayed for the Fed to raise its key lending rates, because without fail mortgage rates would fall. That happens because the Fed does not set mortgage rates, although they can try and influence them.

Mortgage rates are set by the investor demand for mortgage backed bonds (which are sold to generate money for mortgages). These bonds are (in theory) backed by the federal governments guarantee and considered among the safest of investments.

Playing the Market

On the other hand, investors always have the option of playing the stock market. No doubt fortunes have been made there, and they have been lost and there is no guarantee. The stock market if to a great degree fueled by consumer spending and when sales are up on a retail level factory orders and jobs will follow. When life is good for stocks, investors will gravitate toward them and forget about those boring low yield (but safe) mortgage bonds.

When demand for bonds drops, issuers have to pay a higher return to attract money. That pushes mortgage rates up.

So if the Fed raises the cost borrowing to consumers and banks that could dampen demand for consumer goods and hit the stocks. Guess where that money will likely flow? If you guessed the mortgage bond markets, then you get a gold star for the day.

But the Fed does hold a trillion dollar trump card it could play. The last several years the Fed has poured about a trillion dollars into the mortgage bond markets, which is what has driven mortgage rates to the lowest level in decades.

If there is excess demand for mortgage bonds and yields are dropping (and rates falling) lower than the Fed likes, then it could start dumping its holdings in the markets, which would drive up supply and force the markets to adjust to a higher yield (which equals higher mortgage rates). But this move has never been made before, and it would be risky for the Fed to try it.

All of this leaves a great deal of uncertainty in the stock and bond markets, and makes the future of rates unpredictable. My suggestion is if you are looking to buy or refinance, now is the time.

Chris Neuswanger is a loan originator at Macro Financial Group in Avon and may be reached at 970-748-0342. He welcomes mortgage related inquiries from readers. His blog and a collection of his columns may be found at http://www.mtnmortgageguy.com.