How a Fed Rate Hike Will Affect Your Mortgage Rate

Fed rate hike Think a Fed rate hike will affect your mortgage rate? Not so fast.

A Federal Reserve rate hike likely won't impact mortgage rates directly, according to the author of the Wall Street Examiner, Lee Adler.

Adler has over 44 years of experience in the financial industry and previously worked as a commercial real estate appraiser for 15 years.

While he says a Fed rate hike will not have the impact on mortgage rates that many believe, he says there is a separate indicator that will dramatically impact your mortgage rate. And it could impact the entire housing market.

We'll talk about this indicator in just a moment. But before we do, let's look more closely at why a Fed rate hike won't directly affect your mortgage rate.

Why an Interest Rate Hike Won't Affect Your Mortgage Rate

Mortgage rates now move independently of the federal funds rate, Adler said. As a quick reminder for readers, the federal funds rate is the short-term interest rate at which banks borrow from each other. So whenever the financial media refers to a Fed "rate hike," they're talking about the fed funds rate.

In the past, the fed funds rate used to have a significant effect on mortgage rates. But after years of quantitative easing, banks have been flushed with tons of cash. So banks simply don't need to borrow as much from each other.

"Banks are now sitting on $3.5 trillion of excess reserves," Adler said. "The fed funds market is a shadow of what it once was."

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Because of this massive cash pile, banks will continue to lend at low rates independently of the fed funds rate.

However, there is one separate indicator that has a huge impact on mortgage rates. If this indicator rises significantly, it could cause your mortgage rate to skyrocket... and even lead to the next housing market crash.

A Fed Rate Hike Won't Affect Your Mortgage Rate, but This Indicator Will

The 10-year Treasury bond yield actually holds the real power over your mortgage rate... and the direction of the entire housing market, Adler said.

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You see, 30-year fixed mortgage rates have been pushed down to their lowest levels since 1970 (the earliest such data has been collected), according to Freddie Mac. They're currently around 3.3%. A decade ago, rates were averaging around 6.2%. But mortgage rates have been falling in tandem with the declining 10-year T-bond yield. You can see this relationship in the graph below.

Federal Reserve
The 10-year Treasury yield has dropped from 4.63% in September 2006 to 1.58% as of September 2016.

The big reason behind the falling Treasury yield? Foreign investors.

As European investors in particular get pummeled with low - or even negative - interest rates, they've been searching for returns in U.S. bonds. But as more foreigners buy U.S. bonds, yields drop. In turn, this has caused U.S. investors to look for greater returns in the housing market, causing mortgage rates to plummet.

Capital inflows in U.S. markets have been surging by the billions this year. In July alone, overseas investors bought $32 billion of long-term U.S. securities. Those include government and corporate bonds, according to the U.S. Treasury Department.

If these inflows stop, however, mortgage rates could rise. And that could prompt concerns of another housing market bubble similar to the one back in 2006.

Already, home sale prices are about 6% higher than they were at the peak of the last housing market bubble, according to the National Association of Realtors' data from August (the latest released).

The Fed won't be able to stop the housing market from inflating, though. Its go-to policy tool, the fed funds rate, simply doesn't affect mortgage rates anymore.

"The Fed's hands are tied," Adler said.

The Bottom Line: The fed funds rate no longer sways mortgage rates. Homeowners are better off using the 10-year Treasury yield to gauge the health of the housing sector. Currently, Treasury yields are at a historic low because of capital inflows from foreign investors. As long as these inflows continue, expect your 30-year fixed mortgage rate to remain low.

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