Homebuyers and real estate agents are obsessed with the Federal Reserve right now. This is understandable, given the super-steep rate rise over the past year and a half. But it’s a bit misplaced. If you really want to obsess over something, I’ll give you something more fun than Jerome Powell (not that he’s not a fun guy; he probably is). Worrying about the Fed is just not going to inform any home-buying decision at the moment.
A Quick Primer on The Fed Funds Rate
Typically, the Fed has direct control only over short-term markets, the Fed funds rate. This is the rate banks charge one another for overnight (one-day) loans. Why would banks need to borrow for just one day? They’re required to maintain a certain level of deposit reserves; sometimes a bank closes the day lower than its reserve requirement, and sometimes higher. If a Bank A is a bit low, it’ll borrow at the Fed funds rate from Bank B; if Bank A has extra deposits on hand, it’ll lend to Bank B and pocket the interest. Though Fed funds is an overnight rate, it is always stated as an annualized figure, so you’ll see it as a percentage, like 5.25%.
But mortgage markets revolve around a much longer rate: the yield on the 10-year U.S. Treasury. This is the number borrowers need to look at. And its wonky relationship to Fed funds is critical to understand.
The Fed Funds Rate and the 10-Year Treasury: Like Kids in The Same Homeroom
Sometimes they’re super tight and spend all their time together; later in the year, they get distracted and spend time with the kid who acts like Eddie Haskel. The relationship between the Fed funds rate, upon which so many of us fixate, and the 10-year Treasury, is not static. It’s dynamic. It’s ever-changing. It’s a bit unpredictable. It’s kinda like the kids are in the same homeroom and have a sleepover now and then.
Under certain conditions, the Fed funds rate is some fraction of the 10-year rate, and they tend to move roughly in tandem. This situation produces a normal yield curve, which is what we saw, for example, 18 months ago, on March 21, 2022. (Note that the Fed funds rate shown in these tables is called the effective Fed funds rate, which is an average of all the Fed funds trades that day.)
On March 21, 2022, Fed funds was 0.33% and the 10-year at 2.32%. Again, this shape is a normal yield curve, what bond managers kinda like to see.
Yield Curve 18 Months Ago: March 21, 2022
Let’s fast-forward 18 months, to yesterday.
Those kids! They never know what their deal is! Now you see the effective Fed funds rate at 5.33% (all those rate hikes have had an effect, after all) and the 10-year yield at 4.37%. Huh? Fed funds are higher than the 10-year? Well, bond markets are measures of risk, and right now the markets see more risk to the economy over the short term (the next few months) than they do over the long term. They’re not buying all this “soft landing” talk. So short rates are higher and long rates are lower. This is called an inverted yield curve. Not a big deal, really.
Or is it?
The Yield Curve Yesterday: September 19, 2023
When Things Get Unpredictable, Watch the 10-Year!
In fact, you should always watch the 10-year, and the next chart will show you why. Fixed mortgage rates are priced off of the 10-year Treasury (variable-rate mortgages are priced off of short measures, but the vast majority of new home loans right now are fixed).
Now it gets interesting. We’re looking below at yield-curve data that’s six months apart. The green bars are yields as of March 20, 2023, and the blue are yields as of September 20, 2022 (my source for these data is the Federal Reserve Bank of New York, by the way). Note that as of September 20 of 2022, the effective Fed funds rate was still at 2.33%, as the Fed was midway through its tightening cycle. The 10-year at the time was at 3.57%. Six months later, Jay Powell had raised the funds rate a few more times and by March 20 of this year, effective Fed funds was at 4.58% (remember the effective rate is a weighted average of all the Fed funds trades that took place on a given date).
What did the 10-year do? Nothing. Nada. Zip. Yawn. Zero. Numero nada.
With funds having moved upwards by 2.25% in six months, the 10-year Treasury yield sat still, ending that day at 3.47%. The takeaway: 10-year U.S. Treasury yields often moves in the same direction as the Fed funds rate and often by roughly the a similar amount, but not always. Sometimes the relationship gets kinda crazy and wonky. Remember that fixed-rate mortgages are priced off the 10-year.
Yield Curve Comparison: Fed Funds Doubled But The 10-Year Refused to Budge
This Begs The Question: What the Heck?
One can infer that six months ago, the markets (as now) perceived more risk in the short term than they did in the long term, because the 10-year refused to move higher. This is a reasonable interpretation.
What happens if and when the perception of long-term securities having more risk (more time for stuff to go wrong) begins to normalize? 10-year yields would climb, without the Fed having done a darn thing.
In fact, Jerome Powell could sit on his hands for nine months and do nothing (which I’m sure he’d be glad to do, after all this) and the 10-year could climb by half or even a full percent. While it’s the norm to obsess over the rates that are set by a small group of humans called the Federal Reserve Open Market Committee, it’s wiser and more fun to obsess over the rates set by millions of bond buyers and sellers worldwide: the 10-year U.S. Treasury yield.
If you’re in the market to buy a home, ignore Jerome Powell for now. The potential threat of climbing long-term rates is what you should to attend to.
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