The Fed Cut Rates.. But the 10 Year and Mortgage Rates are Rising Again?

Since the Federal Reserve announced a cut of 0.5% (50 basis points in financial jargon), the 10 Year Treasury rate has risen from 3.7% to about 4.3%. For many, this is a bit head scratching. If the Fed is cutting rates, why would things like government bond rates and mortgage rates be increasing? I thought mortgage rates would fall if the Fed cut rates, why are they increasing again? At the end of the day, it really comes down to a couple key drivers of interest rates: inflation, economic growth, and risk appetite.

The Fed adjusts their target rate in an effort to influence short-term interest rates and the cost of borrowing across the economy. This impacts such rates as those charged by banks for lending to each other “overnight” and the rates charged by banks on floating rate commercial loans that are contractually tied to short-term rates. By increasing such borrowing costs, the Fed’s goal is often to slow down the economy when it is "too hot" in order to reduce inflation back towards the Fed’s target level of 2%. In a perfect world, the Fed can drop rates back down once inflation has cooled. In the real world, this is a very difficult task and, if the Fed loosens borrowing costs too early, there is the risk that it could reignite inflation.

In this case, bond investors may believe that the Fed cut too much, too soon, and could reignite inflation. Alternatively, investors may feel more confident about the prospects of avoiding a recession and may have decreased their holdings of safety assets, such as the 10 Year Treasury, in response. Investors often load up on Treasuries when anticipating a recession as inflation and growth rates fall and investor demand for the safest assets increases. This pushes interest rates down and drives up the prices of these bonds. Since longer-term bonds increase in price more than shorter-term bonds when market interest rates fall, the 10 Year has long been a favored asset for playing defense. In a nutshell, short-term interest rates are influenced by short-term economic growth and inflation levels while long-term interest rates can be more influenced by a combination of economic expectations and investors’ risk-appetite.

For longer-term lending, the lender must consider expectations for economic growth and inflation across a period of 5, 10, 20 or even 30 years. For instance, a bank that is lending on a 30-year mortgage is contending with the uncertainty of what economic growth, inflation, and thus interest rates may be like over the term of the mortgage. Mortgage lenders will also often offload loans to investors who are comparing the interest rate they can earn on buying the mortgage to the interest rate they can earn on other fixed income investments such as government or corporate bonds. This risk/reward analysis comes back to the “risk-free rate”, otherwise known as the interest rate being paid by a government bond of a similar maturity length.

Consumer loans such as mortgages and auto loans have historically had a strong relationship with the 10 Year Treasury Bond. Because there is a greater risk that a homeowner will default on their mortgage than there is that the U.S. government will default on a bond, the rates required on a mortgage must be higher that the risk-free alternative, otherwise why not just by a government bond? Over the last 40 years, the 30-year market mortgage rate has been on average 1.77 percentage points above the 10 Year Treasury rate with a maximum gap of 3.30 percentage points (1986) and a minimum gap of 0.97 percentage points (1996). On the other hand, the 30-year mortgage rate has been an average of 3.17 percentage points above the Fed Funds rate but with a maximum gap of 6.16 percentage points (2008) and a minimum gap of 0.44 percentage points (1989). In addition, the rolling 3-month correlation over that period between the 30-year mortgage and the 10-year treasury rate has been 0.9, highly correlated, while the correlation with the Fed Funds rate is much lower at 0.415 on average.

As displayed, the 30-year mortgage rate has historically been much more tied to the 10 Year Treasury rate than it is to the Fed Funds rate. All else equal, the 10 Year Treasury rate should provide investors with a return above long-run inflation expectations, otherwise they are locking in a decline in purchasing power. When short-term inflation expectations are much higher than long-term inflation expectations, a decline in short-term inflation that drives a decline in short-term rates may not have as much effect on something like the 30-year mortgage. After a long stretch of what we would argue were unnaturally low interest rates, we are still in a period of interest rate normalization. If long-run inflation expectations remain above 2%, the 10 Year Treasury rate provides an adequate real yield, and the 30-year mortgage rate is at a premium to the 10 Year, it may be tough for mortgage rates to significantly drop, barring a recession, even if the Fed gradually lowers short-term rates. This is by no means an all-encompassing explanation of interest and mortgage rates, but is meant to serve as an example of why long-term interest rates could be rising while short-term interest rates are cut.