Historically, mortgage rates tend to decline following a Federal Reserve rate cut, but the relationship isn’t always direct or immediate. Let’s break down how mortgage rates typically react to Fed rate cuts and what factors influence these movements.
Short-Term Impact
In the short term, mortgage rates often see a modest drop after a Fed rate cut, but it’s not as simple as it sounds:
- Initial Drop: Mortgage rates may decline within days or weeks of the Fed’s announcement. This reaction is driven by market anticipation and broader economic sentiment, with investors adjusting their outlook on future interest rates.
- Delayed Response: Sometimes it takes weeks or even months for the full effect of a Fed rate cut to show up in mortgage rates. That’s because other factors, like the bond market and Mortgage-Backed Securities (MBS), also play a major role in determining mortgage rates.
Long-Term Trends
When looking at the long-term effects of Fed rate cuts, the impact on mortgage rates becomes more nuanced:
- Gradual Decline: If the Fed signals more rate cuts or maintains a dovish stance, mortgage rates tend to trend downward over time. However, mortgage rates are more closely tied to long-term bonds like the 10-year Treasury yield than to the Fed’s short-term federal funds rate.
- Market Expectations: Often, the mortgage market prices in Fed moves ahead of time. So when the Fed cuts rates, mortgage rates may have already adjusted. In some cases, mortgage rates don’t drop much further because the market has already “priced in” the Fed’s action.
Factors Influencing Mortgage Rate Response
Mortgage rates don’t always move in perfect alignment with Fed rate cuts. Here’s why:
- Bond Market Influence: Mortgage rates are heavily influenced by the performance of Mortgage-Backed Securities (MBS). When MBS prices rise, mortgage rates tend to fall, and vice versa. In periods of high volatility, we often see wider spreads between the bid and ask prices for MBS. This means there’s more uncertainty or risk in the market, which can artificially keep mortgage rates higher even when other factors suggest they should be falling. As volatility settles, these spreads tend to narrow, which can allow rates to decline.
- Economic Conditions: The broader economic environment, including job growth and unemployment, also impacts how mortgage rates respond to Fed rate cuts. Weak job growth can push the Fed to cut rates, but rising unemployment can also bring about broader economic uncertainty. However, it’s important to note that rising unemployment doesn’t always hold mortgage rates high. If the Fed acts quickly to counteract unemployment with more cuts, rates could drop further. The key is in how market sentiment evolves based on the Fed’s actions and overall economic confidence.
- Inflation: Inflation is a key factor in Fed decision-making. When inflation is high, the Fed typically raises rates to slow economic activity, which tends to push mortgage rates higher. Conversely, when inflation is under control or falling, the Fed may cut rates, potentially lowering mortgage rates. Inflation expectations can also affect mortgage rates even before the Fed acts—if markets believe inflation will stay elevated, mortgage rates may remain high despite rate cuts. The Fed’s long-term inflation target is 2%, a level it believes supports both price stability and maximum employment. However, with inflation running above this target in recent years, the Fed has maintained higher interest rates to bring it back down.
- Lender Behavior: Lenders adjust their rates based on their own risk assessments, liquidity, and capacity. For instance, during periods of high demand, like the refinancing boom in 2020, lenders may keep rates higher despite Fed rate cuts due to the operational strain of processing loans.
Historical Examples
Here are a few instances where Fed rate cuts impacted mortgage rates:
- 2008 Financial Crisis: Aggressive Fed rate cuts eventually led to significant drops in mortgage rates, but the cuts didn’t have an immediate effect due to financial market uncertainty and disruptions in the MBS market.
- 2019 Rate Cuts: When the Fed cut rates three times in 2019, mortgage rates gradually fell from 4.5% to about 3.7% by year-end, reflecting market confidence in the Fed’s low-rate policy.
- 2020 COVID-19 Pandemic: Despite the Fed cutting rates to near zero, mortgage rates didn’t drop immediately. A surge in refinancing demand overwhelmed lenders, and the MBS market faced volatility. Over time, mortgage rates did fall to record lows as markets stabilized.
Current Context: August 2024 Jobs Report
The latest jobs report showed slower job growth, with non-farm payrolls rising by only 142,000, below expectations, and previous months’ numbers being revised downward. The unemployment rate also ticked up to 4.2%. Weaker job growth can increase the likelihood of more Fed rate cuts, but rising unemployment adds economic uncertainty, which could prevent mortgage rates from dropping as much as anticipated.
The Sahm Rule, which signals a potential recession when unemployment rises by 0.5% from its low over three months, has been triggered, further increasing the likelihood of a dovish Fed. While additional rate cuts might lead to lower mortgage rates, lenders and investors could become more risk-averse, potentially limiting how quickly rates drop.
The Takeaway
While Fed rate cuts typically influence mortgage rates, the relationship is not always straightforward. As we’ve seen with the recent jobs report, weaker employment growth increases the chances of more rate cuts, but mortgage rates won’t necessarily follow immediately. Mortgage rates are more closely tied to the bond market, particularly MBS, than to Fed policy.
Inflation remains a key variable in determining the future of mortgage rates. If inflation remains high, even amid rate cuts, long-term bond yields—and thus mortgage rates—may remain elevated. Conversely, if inflationary pressures ease, mortgage rates could see more meaningful declines.