Wednesday, September 19, 2007

What If Long-Term Interest Rates Rise?

When the Fed cut its benchmark interest rate by 50 basis points to 4.75% yesterday, the immediate assumption was that long-term interest rates will fall and help out homeowners with adjustable rate mortgages set to reset to a higher interest rate.

But the LA Times says that may not be the case:

The Federal Reserve's interest-rate cut will help many people save money on home-equity credit lines and adjustable-rate mortgages -- but whether it will revive the troubled housing market is far from clear.

One risk is that the Fed's move Tuesday could ignite inflation fears, which could drive up conventional mortgage rates and make matters worse for housing.

"If the Fed does revive inflation it's going to put a damper on housing and other activity in the economy" by pushing up long-term rates, said Gregory Hess, professor of economics at Claremont McKenna College in Claremont


New home buyers and homeowners who want to refinance into a 30-year loan face the biggest question mark, because it isn't certain that the Fed's reduction in its short-term rate will translate into lower long-term mortgage rates.

That's because long-term interest rates are set by the marketplace, not by the Fed. And one key consideration of investors in determining long-term rates is what inflation rate they expect, because inflation eats away at bonds' fixed returns.

If investors think the Fed's credit-easing move could stoke the economy and boost inflation pressures in 2008, that could result in long-term rates rising, analysts warn.

For the beleaguered housing market, that would mean "putting it in a worse bind" than it already faces, said George Goncalves, Treasury-market strategist at brokerage Morgan Stanley in New York.

On Tuesday, the 10-year Treasury note yield inched up to 4.47% from 4.46% on Monday, even as short-term rates fell. Thirty-year mortgage rates tend to track the 10-year T-note.

Still, because the 10-year T-note yield has tumbled from 5.05% in mid-July, 30-year home loan rates also have fallen. They averaged 6.31% nationwide last week, down from 6.73% in mid-July, according to mortgage finance giant Freddie Mac.

The Wall Street Journal also says the Fed's move may not help out mortgage holders because some mortgage rates are tied to the Libor:

There also is likely to be little immediate relief for borrowers with certain types of adjustable-rate mortgages. That's because the rates on some of these loans are tied to the London interbank offered rate, or Libor, which recently jumped sharply above the Fed funds rate because of the continuing credit crunch in the markets. Libor, which has drifted downward recently, is an interest rate charged by banks for short-term loans to each other.

"If Libor doesn't come down, there is no relief" for many mortgage borrowers, says James Bianco, president of Bianco Research LLC, a market-research firm in Chicago.

Homeowners with adjustable rate mortgages tied to the U.S. prime rate will see immediate relief. The major banks dropped their prime rate for borrowing yesterday by a full 50 basis points. But those tied to the Libor, not so much.

Same goes for adjustable rate student loans. Prime-based see relief, Libor-based do not.

Credit card holders will see relief. Interest rates should fall a bit for people carrying revolving debt.

Interestingly enough, I expected to see lower interest rates on savings accounts almost immediately after the Fed announcement, but so far that hasn't happened.

The WSJ says

Some banks have already started to reduce their rates or scale back their deals. Bank of America Corp., for instance, recently shortened the maturities on its promotional CDs paying 5% to four months from eight months.

Nevertheless, banks are going to be reluctant to cut rates before their competitors, in part because consumer deposits remain one of the cheapest sources of funds available for the banks, says's Mr. McBride. In fact, average CD rates have barely budged in recent months with yields on five-, three- and one-year CDs currently at 4%, 3.77% and 3.76%. "That is very uncharacteristic," since CD yields normally move well in advance of a Fed action, he says. "Savers are getting a break."

Citibank actually raised interest rates on its Ultimate Money Account last week to 5.10% from 5.0%. This move came even with the expectation that Uncle Ben would cut at least 25 basis points a week later at the FOMC meeting.

Could it be that banks are so desperate for cash that they cannot afford to lower interest rates on savings accounts for fear that savers will pull their money out and go elsewhere?

I dunno.

Perhaps rates will fall later this week or next week, but as of now, yesterday's Fed cut hasn't lowered interest rates on many savings accounts and that may be a sign that the Fed move may not have the consequences Uncle Ben and his Merry Men wanted it to have.

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