This Week's Blog

When we hear in the news that the Fed (Federal Reserve) cut interest rates... what does that mean?

The Fed is controlling the Federal Funds Rate which is tied to the Prime rate.  The Prime rate is specific to home equity lines and other short term interest rates.  Before the rate cut, the Prime rate was 8.25%.  Now the Prime rate is 7.75% since the Fed reduced rates by .5%. 

There is a common misconception that the Fed cutting rates will lower long term interest rates (ie. 30 yr fixed mortgages).  Unfortunately, the opposite occurred as fixed rates do not work that way.  Long term mortgage rates are based on Mortgage Backed Securities issued by Fannie Mae and Freddie Mac.  It is the trading performance of these bonds that will ultimately affect the direction of mortgage rates.

The key component is inflation. An increase in inflation is negative for any long term bond because future returns are decreased as the bond becomes less valuable. 

An indicator for consumers to watch to determine the direction of bonds is the Nasdaq/ stock market.  As the Nasdaq declines, mortgage bonds benefit causing mortgage rates to fall.  This is due to money managers and mutual fund companies moving funds into either stocks or bonds.  If stocks/ Nasdaq is trading higher, money is taken out of bonds and moved into stocks causing bond prices to drop and mortgages rates to increase.  The opposite occurs if stocks/ Nasdaq is trading lower.  Money managers then sell off their stocks and move money into bonds causing bond prices to go up and rates to go down.

In summary, it is not what the Fed does that causes rates to increase or decrease, but how the Nasdaq/stock market interprets what the Fed does that will cause rates to increase or decrease.