Investor’s Business Daily just had a homebuilder article that repeated the widespread belief that a reduced Fed interest rate will pull down mortgage rates, thereby boosting new home sales. However, that purported link is wrong.
Short-term interest rates do not drive long-term mortgage rates
Mortgages are long-term commitments, so a drop in today’s short-term rates does not translate into a comparable drop in long-term rates. Moreover, and very importantly, if the lower short-term rate is not market-based, but is Fed-caused, its permanence is in doubt.
Luckily, we have the past 37 years as proof of that missing link. August 1987 was the beginning of Alan Greenspan’s terms as Fed Chair. He experimented with a sharp decline to near-0% real (inflation-adjusted) interest rates following two recessions. Those circled areas show that mortgage rates didn’t follow suit. Instead, a large gap opened up. Then, when Greenspan moved short-term rates up, mortgage rates didn’t rise – the gap simply narrowed.
Then came Ben Bernanke’s experiment with negative real interest rates. With inflation running about 2%, his near-0% nominal (non-inflation adjusted) rates caused a steady loss of purchasing power in the under-yielding securities. Here, too, the link with mortgage rates was weak. Under Powell, the 2020 decline was aided by the heavy buying of mortgage securities by both the Fed and the regional banks. That dried up when inflation rose sharply, followed by the Fed’s short-term interest rate raising. Coincidentally, those three forces caused mortgage rates to rise from its higher level.
Now, however, mortgage rates sit at reasonable, market-based levels. Therefore, don’t expect the Fed’s pushing down short-term rates by 0.25% or 0.5% to do much of anything to long-term mortgage rates.
Thus, you can feel free to ignore the popular but overly simplistic and unsupported idea that the Fed can produce a jump in new home sales.
The bottom line: Much of today’s commentary is overly simplistic
This view isn’t criticism, just a view of reality. What is important to realize is that a lot of the “looks good” ideas we read about are helpful in determining a contrary strategy. For example, if homebuilder stocks have just been pushed up because of Fed Chair Powell’s comments, and we understand that’s not sufficient reason to expect a rise in new home sales, we can avoid the potential loss from buying or holding now.
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