Consumers often mistakenly believe that when the Federal Reserve (The FED) reduces short term interest rates, long term rates will also trend lower. Why, then, does the opposite often occur . . . long term rates actually increase when the FED reduces the discount rate.
Here is the theory. While consumers mistakenly believe that the stock market “drives” long term interest rates, it is actually long term bond investments that determine the direction of long term interest rates.
Bond investments typically react negatively to positive economic news, believing that “good news” could lead to an increase in the dreaded “I” word . . . Inflation. It can be confusing to think that a robust economy actually promotes higher long term interest rates while a faltering economy can result in lower long term rates . . . In other words, an inverse relationship to a strong economy.
THE SHORT VERSION OF THE BOND MARKET CONNECTION
Investors view the bond market as a barometer for predicting inflation. The bond market fears inflation because it lowers the value of bonds. Here is the potential problem . . . this “fear” of inflation can sometimes cause bond marketeers to “sense inflation even when none exists”. So, the bond market might react quickly to such things as lower unemployment, an increase in consumer confidence or higher retail sales, all viewed as changes in the “expectation” of inflation. This in turn can affect long term interest rates.
Here is the short version in understanding bonds . . . there is an inverse relationship to bond prices and bond yields. When prices are up, yields are down. We consider it good when bond prices are up because the result is usually lower interest rates.
This is what happens. When the stock market and the rest of the economy is robust, consumers invest and money is withdrawn from the more secure, but less lucrative bond investments. Bond yields must increase in an attempt to attract investors . . . the cost of purchasing bonds declines promoting a higher “yield” to investors.
The opposite occurs when the economy declines, there is often a transfer of funds from a declining stock market to the more secure and stable bond markets. This “flight” of funds to bonds results in a higher cost to purchase bond instruments and a lower yield. Since bonds actually “drive” the long term interest rate market, the lower bond yield translates into reduced long term rates.
TRACKING THE BOND MARKET
If you want to watch the bond market in hopes of predicting long term interest rates . . . Good luck! But, here is how you do it. When you check on the 10 year bond in the paper, on the TV or on the web there will be a yield quote. Let us say the yield is quoted as 3.0. As you track the 10 year bond, this number reduces, typically very slowly. Now, let’s say that the yield has reduced to 2.7, indicating that the price of bonds have increased (this is good for lower interest rates, remember). If, on the other hand, the yield is increasing, say up to 3.3, the price of bonds have likely declined and long term interest rates likely trending a bit upward.
Note that very slight changes in the bond yield can result in interest rate changes. While initially confusing, you will soon get the hang of it. It is helpful to remember that the FED controls only short term interest rates, not bond yields. A reduction in short term rates will be reflected in equity line loan rates, auto loans and Adjustable Rate loan products, not long term, 30 or 15 year home loan rates. Once you understand the relationship, it makes sense that the FED’s actions most often have an inverse relationship to our long term interest rate markets.
Now, we know that the bond markets often view the FED’s reduction of short term rates as inflationary. Why? As these short term rates decline, it is cheaper for companies and individuals to borrower and thus encourages spending. This prompts a “protective” action and can result in an immediate increase in long term rates. Sometimes, this long term rate increase is short lived. When the bond markets “realize” the FED’s actions did not promote inflation, the long term rates often readjust proportionally. That is why immediately after a FED rate reduction, long term rates can spike upward, only to adjust back downward after a few days of reflection and review of market conditions. While this roller coaster action can result in long term rates temporarily spiking higher, followed by a reduction (when the bond market realizes that the FED action was not inflationary), depending upon this to occur is a bit of a gamble. Long term rates might just go higher and stay there!
So, the next time you hear that the FED is expected to reduce or increase rates, think carefully as to your decisions regarding pending home mortgage rates, especially if you are involved in a purchase or refinance transaction and have not “locked in” your interest rate.
What makes this phenomena so exciting and frustrating, is that no one can accurately predict what will occur. Thus, you, the consumer, are just as good a predictor (or guesser) of future rates as those of us who are watching the market daily. Scary, isn’t it?