HSH.com on the latest move by the Federal Reserve

Less than two weeks after the Federal Reserve last cut short-term interest rates and only days after expanding its "repo" operations by nearly $1.5 trillion dollars, the Fed moved up its regularly-scheduled March meeting by several days and pulled out the big monetary policy guns, slashing the federal funds rate by a full percentage point and re-starting Quantitative Easing (QE) programs.

The Fed's surprise move Sunday was to address tightening conditions in the financial markets. For a very long period of time, and perhaps moreso in recent weeks, investors flooded into Treasuries, driving prices up and yields down to record lows, but now have decided that cash is preferable to hold, even if it earns nothing. Banks and other investors who have been holding large positions in Treasuries looked to sell them in order to increase their cash positions to weather the disruption to business from the coronavirus outbreak.

With lots of sellers finding few buyers for Treasuries and other bonds, yields on these instruments began to rise; In hopes of addressing this unwanted tightening in financial conditions, the Fed on Friday expanded its "repo" activity, allowing Treasuries to be exchanged for cash. These repo operations come with a contract for the seller to later re-acquire these bonds at an agreed-upon price.

The expanding of the "repo" market came in two moves just a day apart, where the Fed announced a massive expansion in liquidity, adding an additional $500 billion each to its one-month and three-month repo operations. This came on top of an earlier-in-the-week expansion of $175 billion of overnight funding and $45 billion in two-week offerings, all on top of the liquidity operations already in place. The Fed had been buying up only short-term Treasury Bills to help support keeping the overnight lending rate stable in the range the Fed set for it, but on Friday said it would also now spread this $60 billion monthly buy over the entire term structure of Treasuries, a shift to a QE-like stance.

However, the initial market response to these moved was muted at best, as investors were apparently looking for sell these holdings rather than borrow against them, and support for rates across the spectrum failed to excite them either. Although these expanded lend-and-borrow facilities and QE-type bond buys were barely in place, the Fed quickly realized that they were inadequate to address roiling markets.

This is why the Fed re-started QE, and on March 15 announced that they would be purchasing up to $500 billion in Treasuries and up to $200 billion in mortgage bonds. As they did in the days after the Great Recession, this will help the markets in that there will be a large buyer in place for these instruments regardless of price, so liquidity will be preserved or enhanced. In turn, this will help keep rates from rising at a time where there are more sellers of these assets (Treasuries, mortgages) than buyers. It also will again reinvest all inbound principal repayments from the mortgages it holds into new MBS purchases. Previously, inbound mortgage payments were being used to purchase Treasuries as the Fed looked to change its mix of holdings to only Treasuries over time.

While the initial announcement cheered the markets for a time, it became apparent in just a few short days that the $200 billion would be inadequate as the Fed blew through a large portion of the money very quickly. Stress returned to the markets and mortgage rates were again rising as the week of March 20 came to a close.

On Monday morning March 23, the Fed announced that it would purchase unlimited amounts of MBS and Treasuries. The announcement said that "The Federal Reserve will continue to purchase Treasury securities and agency mortgage-backed securities in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions."

The reassurance that there would be a purchaser in the markets for these instruments regardless of price did finally have the desired effect of soothing frazzled investors as they looked to move virtually everything to cash. Mortgage rates began to settle appreciably as the week of March 27 progressed. As markets calm, this should help rates to continue to retreat, and the prospects for again testing or setting "all-time lows" in the coming weeks or months appear to be rising.

For this cycle, the Fed has been managing policy in a time of "ample reserves", or large cash positions held by banks and others. It has helped meter the flow of this cash into the economy by paying banks to park excess reserves with the central bank and so be able to earn interest. This week, the demand on cash must have become quite severe and reserves were likely draining out of the system far too quickly for the Fed's liking.

At the same time as the initial Treasury and MBS program was announced on March 15, the Fed slashed its policy (federal funds) rate back to near zero. The new official range for federal funds rate is again between 0 and 0.25%, the same emergency level that persisted for seven years between late 2008 and late 2015. There were likely a number of reasons for the large move: First, to try to shock the market and attempt to try to "get in front of the curve"; if the slowdown in economic activity means that the Fed would likely be cutting rates to zero at some point in the coming months anyway, there is little to be lost by doing it now. Second, getting low rates in place now can help lower the cost of borrowing for businesses, so that whenever activity begins to move toward normalcy again, borrowing money to invest and grow will be as cheap as it can be. As few businesses are likely to be are borrowing at the moment, this seems to be more of a preventative measure.

Going into what may be an extended economic interruption, the economy was still performing well. "Available economic data show that the U.S. economy came into this challenging period on a strong footing," noted the Fed in the release which accompanied the close of the unscheduled meeting. However, "The coronavirus outbreak has harmed communities and disrupted economic activity in many countries, including the United States" and "Global financial conditions have also been significantly affected." Although household spending "rose at a moderate pace, business fixed investment and exports remained weak. More recently, the energy sector has come under stress."

The statement also said that "The Committee will continue to monitor the implications of incoming information for the economic outlook, including information related to public health, as well as global developments and muted inflation pressures, and will use its tools and act as appropriate to support the economy."

It further noted that "The Federal Reserve is prepared to use its full range of tools to support the flow of credit to households and businesses and thereby promote its maximum employment and price stability goals," and in additional to rate cuts and QE measures announced "measures related to the discount window, intraday credit, bank capital and liquidity buffers, reserve requirements, and - in coordination with other central banks - the U.S. dollar liquidity swap line arrangements."

While the Fed seems to have pulled out all the stops in recent days, including support programs for commercial paper markets, money markets, commercial and multifamily mortgages and more, they may still have a number of tools available to it to provide economic supports, and we may see these come into play in the months ahead if needed.

As we speculated as might be the case (see the March 13 MarketTrends), the Fed chose not to release an updated Summary of Economic Projections from Fed members. We noted that "There's already too much uncertainty in the outlook and any speculation about the future is likely to turn out to be way off, so there's likely little to be added to the conversation throwing darts at the economic dartboard. That said, if not released, markets may interpret such a move as a sign that the Fed thinks things will become truly bleak and that might roil markets further." Whether this is a contributor to the still-roiling markets on Monday is unclear, and we wonder if this will be suspended indefinitely (or not released publicly, at least) for this meeting or beyond.

The vote to chop the federal funds rate to near zero again 9-1. All voters supported the measures to improve liquidity and market functioning, but one preferred just a 50 basis point cut in the federal funds rate.

The next scheduled FOMC meeting will occur on April 28-29, 2020. Let us hope things are calmer and we have a clearer sense of the damage by that point.

What is the federal funds rate?

The federal funds rate is an intrabank, overnight lending rate. The Federal Reserve increases or decreases this so-called "target rate" when it wants to cool or spur economic growth.

The last Fed move on March 15, 2020 was the fifth decrease in the funds rate since 2008, when the Fed last moved the rate to nearly zero. Originally characterized by Fed Chairman Powell as a "mid-cycle adjustment", the first of the five reductions came in July 2019 and was later accompanied by two additional "insurance" cuts in the federal funds rate. These moves were intended to offset the effects of a "trade war" between the U.S. and China and other nations. After the last of the three moves in October 2019. the Fed said that it expected to hold rates level for the foreseeable future. This of course began to change as the coronavirus pandemic increasingly disrupted economic activity, when the Fed added a half-point and then full-point cut in rates in short succession in March 2020.

By the Fed 's recent thinking, the long-run "neutral" rate for the federal funds may be as low as 2.5 percent, a level well below what has long been considered to be "normal" levels. As such, even if rates do rise over time, they may not get close to historic "normal" levels anytime soon.

The Fed can either establish a range for the federal funds rate, or may express a single value.

Related content: Federal Funds Rate - Graph and Table of Values

How does the Federal Reserve affect mortgage rates?

Historically, the Federal Reserve has only had an indirect impact on most mortgage rates, especially fixed-rate mortgages. That changed back in 2008, when the central bank began directly buying Mortgage-Backed Securities (MBS) and financing bonds offered by Fannie Mae and Freddie Mac. This "liquefied" mortgage markets, giving investors a ready place to sell their holdings as needed, helping to drive down mortgage rates.

After the program of MBS and debt accumulation by the Fed ended, they were still "recycling" inbound proceeds from maturing and refinanced mortgages to purchase replacement bonds for a number of years. This kept their holdings level and provided a steady presence in the mortgage market, which helped to keep mortgage rates steady.

In June 2017, the Fed announced that the process of reducing its so-called "balance sheet" (holdings of Treasuries and MBS) would start in October 2017. In this gradual process, the Fed will trim back the amount of reinvestment it is making in steps until it eventually is actively retiring sizable pieces of its holdings. When the program was announced, the Fed held about $2.46 trillion in Treasuries and about $1.78 trillion in mortgage-related debt. It had been reducing holdings at a set amount and was on a long-run pace of "autopilot" reductions as recently as December 2018.

In 2019, the Fed decided to begin winding down its balance-sheet-reduction program with a termination date of October, but as of August 2019 decided to stop reducing its holdings altogether, ending the program two months early. As the total amount of balance sheet runoff was fairly small, the Fed will be left with a huge set of investment holdings, presently comprised of about $2.08 trillion in Treasuries and about $1.52 trillion in mortgage-related debt. Starting August 1 2019, all inbound proceeds from maturing investments were being used to purchase more Treasury securities of various maturities to roughly mimic the overall balance of holdings by investors.

As well, up to $20 billion each month of proceeds from maturing mortgage holdings (mostly from early prepayments due to refinancing) were also to be invested in Treasuries; any redemption over that amount will be used to purchase more agency-backed MBS. Ultimately, the Fed wishes to have a balance sheet comprised solely of Treasuries, but changing the mix of holdings from mortgages to Treasuries as mortgages are repaid will take many years.

As noted above, the Fed has now re-started QE-style purchases of Mortgage Backed Securities, so not only has the slow process of converting MBS holdings to Treasuries come to a halt, the Fed will again be actively buying up new MBS, so their holdings of mortgages will again be expanding for at least a time.

The Fed will again be buying Treasury securities across the term spectrum, and any purchases of 10-year debt will help to help downward pressure on the yields that most influence fixed mortgage rates.

What is the effect of the Fed's actions on mortgage rates?

For this new cycle, more important than any change in the overnight intrabank lending rate is that the Federal Reserve is again increasing its holdings of Mortgage-Backed Securities (MBS) and Treasuries. Having an active buyer in the market who will purchases these investments regardless of yield will help to keep mortgage rates more steady and likely at lower rates than would otherwise be the case if just private investors were the only market participants.

With mortgage rates recently (if perhaps temporarily) hitting new "all-time" record lows there has been a surge in refinancing activity, so there will likely be a lot of new and lower-yielding bonds for the Fed to absorb as we move deeper into 2020. To start, for the monthly period that runs through April 13, 2020, the Fed expects to purchase around $80 billion in agency MBS, which will include $23 billion in purchases to reinvest principal payments from agency debt and agency MBS expected in the month of March.

The Fed has a massive portfolio of these investments and as they mature or have been paid off (by refinancing) the central bank had been re-investing the inbound funds into more purchases (reinvestment), keeping its portfolio at a constant size. The new actions means that holdings will again be expanding, and while this is a stabilizing factor for the market, the prospects for inflation and continued economic expansion will play a greater role in dictating how interest rates will move.

What the Fed has to say about the future – how quickly or slowly it intends to raise rates or lower rates in 2020 and beyond – will also determine if mortgage rates will rise, and by how much. At the moment, the path for future changes in the federal funds rate is uncertain, and per the Fed's own words will be dictated by emergent conditions and forming trends. With the recent move to near zero again, monetary policy looking forward may look a lot like that we saw at times in the early to mid stages of the record-long economic expansion.

HSH.com Federal Reserve Policy Tracking Graph

Does a change in the federal funds influence other loan rates?

Although it is an important indicator, the federal funds rate is an interest rate for a very short-term (overnight) loan. This rate does have some influence over a bank's so-called cost of funds, and changes in this cost of funds can translate into higher (or lower) interest rates on both deposits and loans. The effect is most clearly seen in the prices of shorter-term loans, including auto, personal loans and even the initial interest rate on some Adjustable Rate Mortgages (ARMs).

However, a change in the overnight rate generally has little to do with long-term mortgage rates (30-year, 15-year, etc.), which are influenced by other factors. These notably include economic growth and inflation, but also include the whims of investors, too. For more on how mortgage rates are set by the market, see "What moves mortgage rates? (The Basics)." 

Does the federal funds rate affect mortgage rates?

Whenever the Fed makes a change to policy, we are asked the question "Does the federal funds rate affect mortgage rates?"

Just to be clear, the short answer is "no," as you can see in the linked chart.

That said, the federal funds rate is raised or lowered by the Fed in response to changing economic conditions, and long-term fixed mortgage rates do of course respond to those conditions, and often well in advance of any change in the funds rate. For example, even though the Fed was still holding the funds rate steady in autumn 2016, fixed mortgage rates rose by better than three quarters of a percentage point amid growing economic strength and a change in investor sentiment about future growth and tax policies during the period.

What does the federal funds rate directly affect?

When the funds rate does move, it does directly affect certain other financial products. The prime rate tends to move in lock step with the federal funds rate and so affects the rates on certain products like Home Equity Lines of Credit (HELOCs), residential construction loans, some credit cards and things like business loans. All will generally see fairly immediate changes in their offered interest rates, usually of the same size as the change in the prime rate or pretty close to it. For consumers or businesses with outstanding lines of credit or credit cards, the change generally will occur over one to three billing cycles.

Related content: Fed Funds vs. Prime Rate and Mortgage Rates

After a change to fed funds, how soon will other interest rates rise or fall?

Changes to the fed funds rate can take a long time to work their way fully throughout the economy, with the effects of a change not completely realized for six months or even longer.

Often more important than any single change to the funds rate is how the Federal Reserve characterizes its expectations for the economy and future Fed policy. If the Fed says (or if the market believes) that the Fed will be aggressively lifting rates in the near future, market interest rates will rise more quickly; conversely, if they indicate that a long, flat trajectory for rates is in the offing, mortgage and other loan rates will only rise gradually, if at all. For updates and details about the economy and changes to mortgage rates, read or subscribe to HSH's MarketTrends newsletter.

Can a higher federal funds rate actually cause lower mortgage rates?

Yes. At some point in the cycle, the Federal Reserve will have lifted interest rates to a point where inflation and the economy will be expected to cool. We saw this as recently as 2018; after the ninth increase in the federal funds rate over a little more than a two-year period, economic growth began to stall, inflation pressures waned, and mortgage rates retreated by more than a full percentage point.

As the market starts to anticipate this economic slowing, long-term interest rates may actually start to fall even though the Fed may still be raising short-term rates. Long-term rates fall in anticipation of the beginnings of a cycle of reductions in the fed funds rate, and the cycle comes full circle. For more information on this, Fed policy and how it affects mortgage rates, see “Federal Reserve Policy and Mortgage Rate Cycles ."

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