I suspect we'll be hearing the same question with increasing frequency over the next year or three, as the Fed’s attempts to "cut interest rates" have the opposite effect. Fact is, Americans don't have much of a clue about the Federal Reserve. That's the main reason I created this blog: to explain what the Fed can and cannot do.
If you scroll down and read those "Basics" postings, you'll see that, when the Federal Reserve "cut interest rates" on Sept. 18th, what it really did was create enough new money to drive the overnight ("federal funds") rate down. Traders reacted by sending rates on 10-year Treasurys from 4.35% to 4.70%. Mortgages are closely tied to the yield on 10-year Treasury notes*, so the increase was quickly reflected in higher mortgage rates.
You see, creating new money is a bit like having sex without a condom: long after the (take your pick: glow, anger, resentment, boredom ...) has worn off, all kinds of other things might happen. This time, the financial traders whose trades set interest rates (other than for those overnight inter-bank loans) took a look at the situation and decided the following:
- Federal Reserve Chairman Bernanke intends to inflate the U.S. out of the mortgage crisis by creating a lot of new money.
- Short-term rates -- which the Federal Reserve can control -- will fall, reducing returns on deposits of U.S. dollars sitting in banks here and around the world.
Let's talk about interest rates. What you pay for a loan consists of three components. The first is a real return to the lender of 1-2%. The second is an expectation of inflation. The third is the default risk investors perceive when they make a loan (or buy a bond, which is essentially a loan made by someone else).
Real rates of return change very little over time, and because the Federal Reserve can create dollars out of thin air if it chooses, interest rates on government bonds have no default component. So, when long-term rates went up after the Federal Reserve "cut interest rates," it was because bond traders decided that inflation is more likely to rise because of what the Fed did, and because of what the Fed might do in the next few years.
How about the dollar? Why did it fall after the Fed's announcement?
Start by imagining that you're the chief financial officer for a big corporation. As part of doing business, you have a bunch of cash. You have to figure out where to put it; you'll want it to be readily available, but while it's sitting there you'd like it to earn the best possible return. If you see the Fed cutting American short-term rates, you might want to buy safe short-term bonds that pay in currencies other than the dollar: for example, Euro-denominated, 90-day bonds issued by the German government.
If this sort of thing happens often enough -- not just among corporate CFOs, but among all of the entities that trade currencies -- the value of the dollar will fall. Currency traders are constantly evaluating various issues, with differences in inflation and interest rates being at the top of the list. In recent years, U.S. rates have fallen while rates elsewhere have risen. More recently, the U.S. mortgage crisis has caused many traders to think the Fed will turn to inflation to reduce the burden of debt accumulated in the past several years.
That's why you've been reading that the Euro, which was worth about 85 cents in the late 1990s, is now priced at $1.41. It's why the Canadian dollar, which was worth around 65 cents a few years ago, now trades for as much as the American dollar. I'd hate to be one of those hotels in Victoria, British Columbia that had been making such a killing from the Seattle-based tourist trade, but I sure wouldn't mind being a European traveler to the United States right now.
The bottom line is this: The Federal Reserve does not, and cannot, set mortgage interest rates. The Fed can "influence" long-term rates by creating and destroying money, and by using some other powers. But that influence is more limited than most Americans believe. Financial markets, not the Fed, set long-term rates through the trading of bonds. And if bond buyers have a motto, it is this: Actions speak louder than words.
-------------------
* Wanna know why rates on 30-year mortgages are based on 10-year Treasury notes? There are three ingredients in that particular stew.
The first is the nature of a bond, Treasury or otherwise. It pays interest every six months and the principal at the end. If you haul out your trusty calculator and do the math, when you consider that the cash flows are paid to you at different times and that the biggest nut (the principal) is paid at the end, the "average maturity," or duration, of all the cash flows on a 10-year bond is 7 years.
That leads us to the second ingredient: It just so happens that the average dwelling gets sold every seven years. Call it a 30-year loan if you want, but chances are that it'll turn over in seven years. As a result, the interest rate is going to look a lot like a 10-year bond because of that bond's seven-year duration.
But why Treasurys? Ah! That's because most mortgages are backed by bonds issued by two federally-chartered companies, Fannie Mae and Freddie Mac. The government doesn't guarantee their bonds, but most buyers think Freddie and Fannie are "too big to fail" and thus would be bailed out by Uncle Sucker anyway. That's why the pricing (and its reciprocal, the yield, or interest rate) of Fannie and Freddie ("agency") bonds is based on Treasurys.
No comments:
Post a Comment