Primary marketFed Raises Short-Term Rates, But Long-Term Rates Drop
Alan Greesnpan and his merry band of policy makers at the Fed did what everyone expected on September 20th -- he raised the federal funds rate by one quarter percentage point, to 1.75 percent. Specifically, the federal funds rate is the rate that banks charge each other for overnight funds. Banks responded by raising the prime lending rate to 4.75 percent, from 4.50 percent. We can now expect to pay a little bit more interest on credit card debt, home equity loans, and other consumer loans.
But what I always find so interesting is the bond market"s reaction to a fed interest rate move. It"s important for folks to understand that the Fed has complete control over certain short-term interest rates, such is the federal funds rate and the discount rate. But long-term interest rates, such as the yield on treasury bonds or a 30-year, fixed-rate mortgage, are controlled by market forces.
Being in the day-to-day mortgage business, I hear it all the time: "We"d better lock in our 30-year mortgage before the Fed meets and raises the rates." Well, for the record, the Fed cannot simply raise long-term mortgage rates. When the Fed decides to make a move with the federal funds rate, it is likely to get some reaction in the bond market but, not always the reaction one might expect.
Let"s take the most recent event as an example. The Fed has made it perfectly clear that they will be raising short-term interest rates at a "measured" pace in order to keep inflationary pressures at bay. In fact, they have raised rates twice this year and have indicated they will continue to do so.
Okay, let"s look at the Ten Year Treasury Bond, a not-perfect but acceptable gauge to determine where long-term mortgage rates are headed. Prior to the Fed"s announcement, the yield on the ten-year note was hovering around 4.12 percent. One day after the announcement (as of this writing), the ten-year fell to 3.99 percent.
When short-term rates rise and long-term rates fall, we have what"s called a "flattening of the yield curve." This means the interest earned by tying up your money for a short period of time increases while the interest earned by tying up your money for a long period gets less expensive.
Here"s what I think is happening. Chairman Greenspan has always been an inflation fighter and has rarely hesitated to raise rates if inflation or the perception of inflation appears. Earlier this year, economic growth was clocked at a brisk 4.50 percent annual rate -- brisk enough for the word "INFLATION" to ring in Greenspan"s ear. So he sets a policy of modest and measured increases in short-term rates, just to make sure inflation doesn"t rear its head. Besides, with the federal funds rate at under two percent, there"s a lot of room to move upward and not much room to move downward. A few small bumps isn"t exactly going to cause an economic depression. So there he goes.
Later in the year, growth sputtered to a lethargic 2.80 percent annual rate. That didn"t stop Greenspan from altering his policy. In fact, he called the slowdown in growth a temporary "soft patch."
Summer goes by, there"s no significant core inflation numbers, there"s no data to suggest that the economy is on fire, the situation in Iraq is uncertain … blah, blah blah.
Enter bond investors. The value of bonds deteriorates during periods of inflation, so the yield on bonds generally rises, as do mortgage rates, when inflation or its perception appears. So far -- nothing. I think investors are buying bonds and causing long-term interest rates to drop because they are not as optimistic about the economy as the Fed is.
Time will tell who is right. But the last time the yield on the ten-year bond was as low as 3.99 percent, I was up to my neck in refinance business. Homeowners might want to check their mortgage note -- another refi "mini-boom" may be imminent.