Fed rate, T-bills and Mortgage rates… Oh My!!!

Around every water cooler in America we’ve all been discussing that the Federal Reserve has been steadily increasing rates from the historic lows we’ve seen for the past 10 years, and is currently hovering between 2 and 2.5% as of the writing of this post.

But what is the Federal Funds rate? (and honestly, why do I care?)

The Federal Funds Rate is the interest rate that banks extend short-term, overnight loans to eachother so that they meet minimum bank reserve requirements. As the Fed increases rates, banks must keep more funds on-hand at the bank or they must elect to pay more to borrow from another institution to meet these requirements. So, banks have to hold tighter to the money that they have. From a 10,000 foot perspective this restricts the overall availability of cash within the US economy and slows investment. This causes business to grow and hire workers more conservatively and keeps the US economy as a whole operating at a sustainable level. When the US economy weakens (i.e. high unemployment numbers, etc.) this process is reversed and Fed rates are decreased.

While the Fed rate does not have an immediate impact on things like mortgage interest rates, it does have an overarching impact on the economy, consumer and investor confidence, and investment decisions made based on the consumers’ and investors’ level of confidence.

A better indicator of mortgage rate changes is the treasury bill (T-bill rate) as investors compare all fixed-income investments against one another. In this comparison, T-bills are fixed income investments that are backed by the US government, meaning that their risk is very low, therefore, to be deemed as attractive to investors other fixed-income investments must offer a higher rate of return to counter-balance the additional risk that the investor must take on with things like mortgage-backed securities. Instead of being guaranteed by the US government these investments are supported by the value of the consumer home loans they contain. Relying on consumers to pay their mortgages and associated interest payments carries significantly more risk to an investor than the US government. Therefore, as treasury rates of return increase, the returns available to investors in mortgage-backed securities must also increase (i.e. mortgage interest paid by the consumer), otherwise these investors would switch into the less-risky government bonds.

While the Fed rate does not have a direct impact on mortgage rates for consumers, overall, an increase in the Fed rate and treasury bill rates of return cause pressure on consumer mortgage rates to keep the balance of risk and reward in the investment arena. So, without any signs of decreasing Fed rates, expect mortgage rates to continue to climb over the foreseeable future.


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