June 23, 2013 12:00 am • Barry Nielsen
If someone tells you that they know which direction mortgage rates are headed, don’t believe them.
It’s certainly a good thing to have an educated and informed opinion about the direction of interest rates, but it is impossible to say for certain where mortgage rates will be a week from now, a month from now, or even tomorrow. There are a lot of variables that determine mortgage rates, just as there are a lot of variables that determine stock prices, and currently there is one very large variable that all financial markets are watching very closely. That variable is Federal Reserve monetary policy.
The United States Federal Reserve controls the supply of U.S. dollars in the global economy. Just as with any other good, the supply and demand for dollars determines the price. The price of the U.S. dollar is measured by two very closely related things: foreign exchange rates and interest rates. When the Federal Reserve increases the supply of dollars, it does so with the intent of pushing interest rates lower. However, when speaking of interest rates, there is more than one price. There are short-term interest rates, intermediate-term interest rates and long-term interest rates. Traditionally, the Federal Reserve has only targeted short-term interest rates. Throughout most of the history of the Federal Reserve, financial markets were left to determine what longer-term interest rates should be. However, in November 2008, in the aftermath of the “financial crisis,” the Federal Reserve determined that they could stimulate economic activity by lowering longer-term interest rates.
In order to lower longer-term interest rates, the Federal Reserve initiated several rounds of bond purchases known as quantitative easing. Since 2008, the Federal Reserve has purchased over $2 trillion of U.S. Treasury bonds and mortgage bonds. The yield, or rate, on treasury bonds serves as a benchmark for the yield on mortgage bonds, and the yield on mortgage bonds determines consumer mortgage rates.
By decreasing the supply of treasury and mortgage bonds, the Federal Reserve pushed the price, as measured by mortgage interest rates, to all time-lows. At the same time, the Federal Reserve greatly increased the supply of dollars.
To purchase all those bonds, the Federal Reserve literally printed dollars. These dollars find their way through the economy. The hope of the Federal Reserve is that
they would find their way through the economy in the form of business loans and investment, which would in turn create jobs.
On Wednesday of this past week, the Federal Reserve confirmed to financial markets what it had been hinting at for the past month — that based on their economic projections, their bond purchases are likely to slow by the end of this year and end by the middle of next year. This has had a very large impact on financial markets. Investors in stocks are jittery that less money creation and higher interest rates mean less demand for stocks, and bond investors are jittery that fewer bond purchases means greater supply which has pushed the price, as measured by interest rates, higher.
The Federal Reserve said that the pace at which their bond purchases would wind down would be a function of the strength of the economy. This means that more so than ever, markets will be paying very close attention to economic data and new releases.
Currently, the most important economic news release, which has the biggest impact on markets, is the monthly Employment Report produced by Bureau of Labor Statistics. This report establishes the official unemployment rate and gives the number of new jobs created or lost in the preceding month. The Federal Reserve has stated that it will keep short-term interest rates at current levels until the unemployment rate reaches 6.5 percent. They also suggested that the bond buying would not be entirely eliminated until the unemployment rate reached 7.0 percent. The unemployment rate is currently 7.6 percent.
In conclusion, financial markets provide us a forward-looking opinion through current pricing of what the Federal Reserve might do and how the economy will react. Over the last several weeks, and especially following the Federal Reserve’s comments on Wednesday of this past week, the market’s view, as evident by rising interest rates, has been that the Federal Reserve will slow its bond purchases and that there is enough forward momentum in the economy to push interest rates higher.
Keep a very close eye on incoming economic data and news reports, especially the next Employment Report to be released at 10 a.m. MST on Friday, July 5. The strength or weakness of that number, and other economic numbers, will have a larger than usual impact on mortgage rates.