FED Rate Cuts Are Coming, but Lower Interest Rates Have Already Arrived

In the worlds of real estate and finance, things can change very rapidly. A positive or negative economic report, data point, or headline can move markets and strongly impact consumer sentiment. In the quest to allocate huge sums of money based on future predictions, expectations can quickly become reality. Earlier in the year, we saw mortgage rates increase as several higher than expected Consumer Price Index (CPI) reports and strong employment numbers showed that inflation was not approaching target levels and the economy was remaining strong. With these reports, the probability of FED rate cuts in the near term evaporated, sending interest rates higher. At the time of this writing, in mid-August 2024, we are seeing improvement in the metrics that could lead to the FED finally cutting their funds rate after more than two and a half years of aggressively raising it and the market has, once again, already digested this data and adjusted forward expectations.

In the most recent jobs report, released in early August, non-farm payrolls added far fewer than expected jobs in July, which led to a stock market sell-off and sharply decreased bond yields. In the July CPI report, released in mid-August, the consumer price index came in as expected at a .2% month-over-month increase, following two months of flat or slightly negative CPI growth, and a 2.9% annual increase, the lowest in over 3 years. The FED has indicated that they will cut rates based on this type of sustained data, and is almost certain to cut their funds rate by a minimum of .25% in September. By the time you read this, it will have already happened, but mortgage interest rates are already down close to 1% since July since the bond market expects this. The statement following the rate decision will guide the market as to what future rate cuts to anticipate and has the potential to move rates more immediately.

It is also important to note that the FED funds rate is not directly tied to the interest rates people pay for 30-year fixed mortgage loans. Some floating rate loans do track the FED funds rate or prime rate, but the 10-year U.S. treasury yield combined with a variable credit spread are on what long-term mortgage rates for residential real estate are based. Expectations for the FED funds rate play a large role in the movement of U.S. treasuries, which are considered a safe haven, zero-risk asset. Credit spreads are risk premiums added to incentivize bond investors into buying similar duration, but riskier, bonds than U.S. treasuries, such as for companies issuing debt or mortgage bonds. A return commensurate with the risk is needed for an investor to choose a certain investment over other investment options, which is why mortgage rates will never be as low as the 10-year treasury yield. The spread on a mortgage-backed bond fluctuates, often being higher in times of economic fear, but is often about 2.5% above the 10-year treasury yield.

The current FED funds rate is between 5.25-5.5%, although at this time, both the 10-year and 2-year U.S. treasury yields have moved just under 4%, which implies the market expects approximately 150 basis points of FED cuts in the next year. Mortgage interest rates (the amount a bond holder requires to invest in mortgage-backed securities rather than U.S. treasuries or some other investment) in the mid-6% range. So, as they say, expectations are already baked into the market, and waiting for the rate cuts to actually happen might not have any additional impact on rates.

The efficiency and forward-looking nature of financial markets mean expectations move the market, not the actual event. You might have heard the expression, “buy the rumor, sell the news”, and this applies here. By buying the rumor, you should assume that mortgage rates have already come down for now. They might come down more at some point in this cycle, but it will not be because Jerome Powell presses a magic button notifying lenders of a rate cut. It will be because economic data and/or FED comments lead the bond market to believe they will cut rates further or sooner and the expectations will get baked into interest rates before the FED has a chance to act.

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