The Fed has set the stage for 2016

So what is this interest rate everyone keeps saying the Fed is going to raise and what does that have to do with mortgages?

images3The rate the Fed has raised what is called the “Fed Funds Target Rate”. Fed Funds are the loans member banks of the Fed lend each other (usually overnight) to move funds from banks with excess capital to banks who are capital deficient on a short term basis. The “Target Rate” is therefore just a “suggestion” by the Fed as to what these banks should charge one another. The “Fed Funds Effective Rate” is the actual rate these banks negotiate with one another as these uncollateralized capital loans are actually made. It is a foregone conclusion that member banks will follow the Fed’s recommendation and increase the rate they charge one another for these short term loans, and the “Effective Rate” will immediately move to the Target Rate set by the Fed. A ¼% increase has already been factored into the stock and bond markets over the past few weeks so the execution of this increase may not have a significant impact on either stocks or bonds.

 

Fed Funds are at the extreme short end of the yield curve, while 30 year fixed rate mortgages occupy the extreme opposite long end of the yield curve. Normally the longer the term of the loan the higher the yield required by investors to hedge against the erosion of inflation on their investment. As a result there could be two very different reactions from long term bond investors:

  1. They could view this Fed Funds increase as a preemptive strike against future inflation and therefore a positive for keeping long term rates near present levels (a flattening of the yield curve)

Or on the other hand

  1. They could see a rise in the short end of the curve as the beginning of a rise in all rates of return and see a need to get ahead of higher yields by increasing rates now ( a steepening of the yield curve)

As I have always said you’ll never meet a one armed economist because there is always “on the other hand.

 

Long term mortgage rates are not immediately or directly impacted by the move in Fed Funds rates in the manner credit cards and other short term loans are, but they certainly will be influenced over the long term by which interpretation the investors in long term bonds conclude. Rates of all durations tend to follow this same pattern as Fed Funds are the lead indicator of all durations. As a result expect long term rates to trend upward in 2016.