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How do interest rates “work”, and what is the Federal Reserve telling us?

Updated: Jan 23, 2019

It’s a common question that I hear….but not so easy to answer without it sounding like an Economics lecture: What makes mortgage interest rates go up or down….how can we predict/understand it?


So lets try to review this WITHOUT it becoming an Economics lecture! I’m going to generalize just a bit…rather than getting into the weeds. But this is what you really WANT to know!


Money makes Money!


So you’ve heard this cliché before…it takes money to make money. And what that really means is that a volume of money generates a greater volume of money. Where this is easily observed is on the stock market….good ol' Wall Street.

The more “people” who invest “more dollars” in a stock…the more valuable that stock becomes. If people pull dollars away from a stock…the less valuable it becomes. Right? That’s easy enough to understand.

So when we think of Wall Street….its important not to think of "the market" as JUST the “stock market”, because that is only half of the equation. Rather….its the stock market AND the BOND market that makes up "the market". These two are intrinsically tied together. Let me explain....


The stock market is “risky business”. You can make a LOT more money a lot faster in the stock market, than most any other places you might invest your money. But as good as the rate of return can be with stocks….so too can be the rate of loss! Things move fast, unpredictably at times, in the stock market. So….when its good its great….but when its bad people want out, fast!


That’s not to say that investors SHOULD get “out” of the stock market just because of momentary fluctuations in stocks. In fact, conventional wisdom is that an investor should ride-out the ups and downs, and keep their eye on the “long-game”. History has proven that to be very good advice over more than a hundred years. But this is a whole other topic than what we are here to discuss today....mortgage interest rates!

So why am I talking about stocks? Why, when we are discussing how mortgage interest rates are driven up or down? Well….because mortgage interest rates are tied to.... BOND’s!


Huh? That’s confusing! If mortgage interest rates are tied to bonds…then why all the talk about the stock market? Read on.....

First of all…what is a bond? A bond is a contract between an investor and (mostly) the US government. A very simple contract. The investor gives the government a certain amount of money to hold onto for a time, and the government guarantees a certain rate of return on that money. Its guaranteed…its their “bond”. There’s virtually no risk in it. The government stands behind the contract.

So that being the case…why wouldn’t everyone just invest in bonds? Well…because the rate of return is far lower than the more exciting potential upside of the stock market. In the stock market, there are no guarantees….but if your timing and decision-making (or luck!) is good…the rate of return is comparitively excellent!


So lets review:

1. Stocks have (pretty much) the best rate of return (when stocks are going up).

2. Bonds have a much lower rate of return….but they are SAFE...guaranteed.

3. Investors shouldn’t generally react too sharply to momentary fluctuations in the stock market.


But for a variety of reasons, as diverse as there are a variety of people….many people DO react swiftly to stock market movements….especially when stocks start to move DOWN.


Money makes money….remember? So the more people there are investing dollars in stocks….the more those stocks are valued. The less people/dollars…the less those stocks are valued. Simple enough.


Of course, different investors have different views and objectives about their investments. But you can see how the movement of a mass of people and dollars OUT of stocks, can affect every investor in the stock market. It devalues stocks as money moves out.

And there is often no telling what piece of news, or predictions, may cause a mass of people and dollars to jump out! Sometimes….its nothing more than “following the crowd”. Many investors may have no idea what “fundamental information” triggered a “sell off”. They don't have time to care! All they know is that stocks are starting to go down, everyone else seems to be jumping out….so they are out too! This is how a “mass of people” is formed.


However, investors most ALL agree with one simple thing. The ONE place they NEVER want their money to be placed: is in their own pocket! In their pocket makes ZERO rate of return! Their pocket is perhaps a safe place….but it’s a place that makes the investor NO rate of return….often called “parking” money. Money sitting in your pocket is money no longer invested.

So if you are an investor and you want to always go up but never go down…(and who doesn't?!)….then your money (whether it’s actually you, or some money manager who controls the funds for you) is typically bouncing back and forth between the stock market and the bond market. When stocks are good….you are moving money into stocks. When stocks are bad (going down), you are moving that money out of stocks and putting it in the next best place….BONDS. It’s a safe place, and it earns a guaranteed (but lower) rate of return!

Ok….back to mortgage interest rates (finally!). Almost all mortgage interest rates are “based” on the daily values of bonds. Earlier, I promised not to get into the weeds of Economics….so suffice it to say that it doesn’t really matter which particular bonds are being used, or why mortgage interest rates are “tied” to bonds at all. Just know that its bonds, not stocks, which move mortgage interest rates. Bonds are a financial INdicator (an INdex), which determines whether mortgage interest rates are going up or down.

Based on everything we’ve just gone over…its pretty clear to understand how the stock market can be a good predictor of the bond market….and thus of mortgage interest rates. If stocks are going down BROADLY…that means that investors are pulling enough money away from stocks, and putting that same money IN to BONDS. If ENOUGH investors move towards bonds, it will drive the price of those Bonds upwards due to the increased volume. Once again, Money makes Money!


That’s great for those investors. They are now earning a rate of return, rather than losing money in the stock market, now in a "safe place". At least their money isn’t “parked”!


But if enough investors are driving the value of bonds upwards....mortgage interest rates are likely to move upwards.


Now....this is a bit over-simplified, so as NOT to turn this into an Econ 1-0-1 lecture. You can't simply assume that EVERY time you see a DAILY drop in stocks, that means that mortgage interest rates are going to go up, or down. This is because both of these markets, stocks and bonds, are broken up into sectors.


You've probably heard of the Tech sector, the Energy sector, the Healthcare sector, and many more....various industries that make up the total economy. A move in just one sector (the news of the day that affects a particular sector) may not drive enough volume of investors to move away from stocks, and towards bonds, to materially effect mortgage interest rates. Sometimes, if the news of the day is isolated to just one or only a few sectors, not enough volume to have an impact, then mortgage interest rates might not move, or might even get better!


But....if the news of the day and its effect on the stock market is broad enough to affect many (or all) sectors....then a voluminous move away from stocks is likely to increase mortgage interest rates.


So you can watch the stock market (and relevant news which is likely to affect the stock market) and it is a very good predictor of what mortgage interest rates are likely to do. If stocks appear as if they are about to go down broadly….mortgage interest rates are very likely about to go up. Now you know why....


Its because most of that money that gets pulled out of stocks, gets reinvested into bonds. That drives up the value of bonds….and bonds is the “index” by which mortgage interest rates are tied to.

Conversely, if stocks are doing well enough…..more investors are pulling their money OUT of bonds, at its lower rates of return, and reinvesting those same dollars into the stock market for its (momentary) higher rates of return. This action devalues bonds, which as the index for mortgage interest rates, drives mortgage rates down.

Lastly, there are some particular factors which influence these markets (stocks and bonds) that we should consider….


Stocks represent companies and industries. You know…like Apple stock or Amazon stock. The better companies and industries are doing economically, the better those stocks will do. That’s simple enough.

One of the most common factors which triggers a Broad fluctuation in STOCKS is the Federal Reserve Board. One of the primary things that the Federal Reserve Board does is to adjust the interest rate that the government lends TO banks.


Now, once again, I promised not to get into the economic-weeds….so follow close real quick….


Don’t confuse talk of the Federal Reserve (the "Fed") raising "interest rates”, with this referring to MORTGAGE interest rates! Mortgage rates are NOT the rates that the Federal Reserve is controlling. At least not DIRECTLY...


Rather, the Federal Reserve is controlling the interest rate the major Banks must pay when THEY borrow money from the government. BofA, Wells Fargo….you know….BANKS!

So if a bank must itself borrow money at a higher interest rate…..that bank will in turn offer a higher interest rate on loans it makes to people, and companies and industries.

When you hear that the Federal Reserve is considering a rise in “interest rates”….what that ultimately means is that the cost of borrowing money from banks is about to go up for all sectors. And if, because of higher interest rates, loan payments become higher for companies and industries, who borrow money from banks to operate and function their businesses, then its likely this will have a broad negative affect on the profitability of these companies and industries.

Less profitable? What do you think that will do to the value of the stocks which represent those very companies and industries? Less is Less! Sounds exactly like the kind of thing that can set-off a mass of people to think they should pull out of those stocks.


And so the cycle begins…..


THAT is why mortgage interest rates go up. NOT because the Federal Reserve raised mortgage rates…. Because investors got the jitters, because the companies and industries which they invested into (stocks) may become less profitable, so these investors pull out and reinvest into safer bonds.

If its enough volume, Bond values go up.

Mortgage rates are tied to bond values....

You get it by now!


So here we are in January 2019 at the time this is written. What has the Federal Reserve recently told us?


A little history, for clarity: After the “mortgage melt-down” of 2008 and the subsequent “great recession” which followed, the Federal Reserve Board dropped Bank-rates to ZERO, for the first time in over a century. They did this to help aide recovery of the economy. Rates were held at that spot (ZERO!) for nearly 9 years! Then, during 2018, for the first time in almost a decade, the Federal Reserve started to raise Bank rates back upwards. A quarter of a percent at a time (.25%), again and again and again throughout 2018.


You can imagine how unpredictable and scary that had to be for investors, as the companies and industries they were invested into (stocks) suddenly had to deal with higher bank-loan interest rates. Were these companies and industries strong enough to handle this extra financial burden? This is scary to investors who invest in those very stocks! And thus, we’ve seen quite a bit of market fluctuation in 2018. And we’ve seen mortgage interest rates rise, and fall, and rise again.

Traditionally…..the Federal Reserve aligns the position of Bank-rates to any evidence of “inflation/deflation” of the US dollar. Now I’m not even going to “go there”…..because describing Inflation/Deflation truly IS an economics lecture of the highest order. But suffice it to say that throughout 2018, the Federal Reserve raised Bank-rates multiple times to return them BACK to where they “should have been” if the natural economy hadn't needed a dose of Red Bull from the Feds back in 2008, when the Feds manually dropped rates to zero. However, these increases to Bank-rates the Fed initiated during 2018 had nothing to do with Inflation.

Going forward into 2019, the Federal Reserve has already told us that they intend to let “natural market inflation/deflation” be the traditional indicator of Bank-rates….like it should be. And as we sit here today (January 2019)…there is little to no indication of Inflation within our economy, the TRUE cause of rising Bank-rates.


So what can we take from this? Rates should stay lower and more stable in 2019 than they were in 2018! And THAT is good for OUR company and OUR industry.


Put all of this together and you hopefully understand a little better HOW and WHY interest rates rise and fall, what to expect in 2019 (we don’t have a crystal ball to predict the future, but we do have the knowledge and experience to analyze this in good faith), and what to watch on a daily/weekly basis, as an indicator of what mortgage rates are likely to do.

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