- The Washington Times - Thursday, December 22, 2005

On Dec. 13, the Federal Reserve Board of Governors unanimously agreed to raise a benchmark short-term interest rate by 0.25 percent. The federal funds rate, which is the rate that lenders charge each other for overnight funds, was raised to 4.25 percent. This was the 13th rate hike in the last 19 months.

As is typical, I received a number of calls from homeowners who expressed concern that mortgage rates have risen again thanks to the Fed’s decision. And for the 13th time in 19 months, I had to explain to the callers that an increase in the federal funds rate doesn’t necessarily equate to a rise in mortgage rates.

In fact, long-term rates, such as yields on treasury bonds and 30-year fixed-rate mortgages, dropped slightly on the news.

The Fed has some direct control over short-term rates because it can adjust the federal funds rate at any time. Other similar short-term and adjustable rates will follow suit. Examples include rates on credit cards, the prime rate, which is often used for business loans and home equity lines of credit, and short-term treasury bills.

Adjustable-rate mortgages are also affected because most ARMs are tied to some type of short-term interest rate.

But long-term rates, such as 30-year fixed-rate mortgage loans, compete with similar financial instruments in the marketplace. Investors purchase long-term treasury bonds, corporate bonds and mortgage-backed securities.

How much an investor is willing to pay determines the yield. A strong demand for long-term investments will result in falling yields. This, in turn, causes long-term mortgage rates to fall.

So, contrary to what many people think, market forces play a much bigger role in determining fixed-rate mortgages than the actions of the Federal Reserve Board.

Logically, though, it would make sense that long-term rates would eventually riseif short-term rates rise because investors demand a higher yield for longer term commitments.

The Fed has been betting on this scenario for the last 19 months. In an effort to stave off inflation, the Fed has been raising rates in order to cool off the economy and the red hot housing market.

The Fed surmised that long-term rates would eventually rise in response to the rapid increase in short-term rates.

As I said, logically, the plan should work. The problem is that the market disagrees with the Fed. While the federal funds rate has risen from a 40-year low of 1 percent to the current 4.25 percent, long-term mortgage rates have risen by only about 1 percent during the same period.

When short-term rates equal long-term rates, we have what’s called a flat yield curve. If short-term rates exceed long-term rates, we have an inverted yield curve. History has shown that an inverted yield curve is followed by an economic recession, which is usually followed by a drop in long-term interest rates.

By some standards, we may already be experiencing an inverted yield curve. Homeowners with home equity loans tied to the prime rate are paying more than 7 percent. Meanwhile, 30-year fixed-rate mortgages are hovering just above 6 percent.

So, 2006 will be an interesting year. I’m not one to make any predictions, but don’t be surprised if long-term rates start to fall at some point.

Henry Savage is president of PMC Mortgage in Alexandria. Contact him by e-mail ([email protected]).

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