Fed funds and Mortgage rates

Fed funds and Mortgage rates

I hate doing the eye-ball thing but although mortgage rates are more closely aligned with the 10 year treasury, it sure looks like they do have some relationship with the Fed funds rates. There is obvously a correlation coefficient out there and if I were still at the university I could tell you what it is.

But again eyeballing it shows an even stronger relationship with the 10 year treasury. What do mortgage rates do now that the Fed has lowered the Fed funds rate by 25 basis points? Very little. In fact the Mortgage Bankers’ Association is predicting a rise in mortgage rates by year end. Why? Because the 10 year treasury is expected to rise because of the continued inflation. Again, in order to preserve purchasing power, buyers of long term bonds demand higher yields when there is expected inflation. So even if the tariffs cause only a one time jump in the price level, bond holders will still want higher yields.

Mortgage rates typically are between one to two basis points higher than the 10 year Treasury which is used as a benchmark rate because their durations are almost the same as that of mortgages. This is because many mortgages mature well before their term (houses are sold and/or mortgages are refinanced). Duration (often called the Macauley duration) is defined as the length of time it takes to recoup an investment or as we tell our students it is the weighted average time until cash flows are received where the weights are the present values of the cash flows. Thus duration is less than maturity since there are interim cash flows – Treasury bonds pay a semi-annual coupon making duration shorter than term to maturity. The only bond whose duration is equal to its maturity is a zero coupon bond.

Here is the formula for Macauley’s duration:

3 thoughts on “Fed funds and Mortgage rates”

  1. Most of us have not envisioned such a formula since Klaatu got ahold of the professor’s chalkboard..

    “County Facing Bleak Budget As Bonds Come Due” : not to support the Knox Focus, but this is a shocking headline, this recent August..

    Chris Caldwell is saying payments have come due on county bonds..
    After all the development , taxable new homes, new businesses— “ We’re in the red.”.

    He says county has to cut services or raise taxes, which is directly fm Wealth Management: ..’ Ultimately, ( national) bond buyers would like to see spending cuts or increased taxes to bring Treasury supply lower..’

    Bonds are just more funny-money, until it affects me, a non-bond citizen.

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      1. Thank you for that, and I guess there are different levels of bonds…
        CC says no new bonds have been issued to defray costs. ….There is a med term called spiraling continuum, and if we are in red now , more bonds to cover bonds-due , that sounds like a Ponzi scheme.

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