Stocks broke their winning streak yesterday amidst confusion amongst investors on what they should be watching now to inform them on the next move in stocks. New Home Sales were muted in August but not as bad as expected.
Focus on what’s important. Interest rates are confusing. We know that they are important… stop… if you weren’t sure prior to 2022, you SHOULD know by now. After these past few years where many new… and some seasoned stock investors were educated on their broad influence. Now that it is on the radar, many are still confused over who is in charge of those interest rates.
The easy answer is to attribute responsibility to the Federal Reserve FOMC. Those policy makers are LOUD, they talk a lot, and, yes, I talk about them quite often. Their talk and actions these past few years has indeed wrought havoc on portfolios, making retirement a moving target for many investors. Now with the Fed clearly pivoting into “cut” mode, there is a sense that we are descending on the back side of the mountain of pain. Stocks, no longer held captive by interest rates, will simply soar toward the sun. Mortgage rates will fall back to unfathomable fathoms. Real estate developers will no longer be under water allowing them to lower sky-high rents. All will go back to the old normal now that the Fed has cut rates by -50 basis points, a two-for… and two is almost always better than one. Do you feel like you are being set up? Well, you are, kind of. Let’s take a quick look at “interest rates” since the Fed cut.
In the days just before and right after the Fed’s cut, I spoke with many seasoned media folks about the cut and its importance to average folks. I wrote about it here as well, more than once. It was an unpopular notion, but for the most part, my position was that the “big” rate cut would do nothing for homeowners. I think that I disappointed a few reporters🥺. Everyone was hoping to hear something like “now mortgage rates are going to come down, financing will be cheaper, the housing market will get a boost, and households will have more money to spend.” No, my message was simple. Any benefits from these rate cuts were already realized prior, and they probably had nothing to do with rate cuts at all. Are you disappointed in that statement?
Let me explain. Conventional mortgage rates are not really tied to the Fed and its “key” lending rate Fed Funds. No, they are more closely related to 10-year Treasury Note yields. Those, my friends, are in the hands of bond traders. Now, the Fed can certainly influence those yields, but only by buying and selling notes in the open market… which they do in QE and QT. But for the most part, 10-year yields are influenced by traders. When traders expect rough market and economic seas ahead, they buy Treasury notes which pushes yields lower. A weaker economic outlook also implies lower demand, which leads to lower inflation. If inflation is lower, then bond investors need less yield to compensate for inflation. This allows yields to come down. THAT HAPPENED, AND it had nothing to do with the Fed. In fact, if you are following me, you would conclude that the Fed acted last week for the same reason that 10-year yields came down throughout the summer. Ok, ok, I realize that I may be confusing you. Just check out this chart and all will become clear.
On this chart, I have plotted Fed Funds Rate (green line), 10-year Treasury Note yields (black line), and 30-year Fixed Mortgage rates (blue dashed line). Now observe. Note yields have been declining all summer long. Mortgage rates have also been falling all summer long. Can you see how both of these follow a similar path? That’s because mortgage rates are based on the Treasury, as asserted earlier, but now you can see it for yourself. Now notice that Fed Funds had the parking brake up, and fully engaged until last week. Notice what happened after the Fed cut? Crazy. Treasury yields bounced up… AND WITH THEM, MORTGAGE RATES. Is it clear yet?
Now, home equity loans are a more complex beast. They are more closely tied to shorter term Treasury yields which also, for the most part declined prior to the rate cut. However, some HELOCs (home equity lines of credit) are tied to SOFR (Secured Overnight Financing Rate), which is tied extremely closely to the Fed Funds Rate. So, for those homeowners seeking to borrow using HELOCs or for those who already have them, I will concur, that those folks will get some relief in their monthly budgets. Finally, there is the Prime Rate, which is also tied to Fed Funds. It too is used to price certain home equity loans, so the rate cut will provide some relief in that corner of the lending market.
Up until now, I was only focusing on residential home mortgages and equity loans. I don’t have time for a deep dive on commercial real estate lending this morning, but I will tell you that those are very much tied to SOFR, which is tied to Fed Funds. That corner… that BIG corner of the real estate market will certainly be positively impacted by last week’s cut and will benefit from further cuts in the future. Unfortunately, that will not translate into any benefits to average consumers like you and me for some time… if ever.
What I want to leave you with is that, yes, last week’s Fed Funds Rate cut was generally a good thing for stock investors and borrowers, however, there were many benefits of lower rates being enjoyed well prior to the Fed’s action. And, unfortunately, those lower rates were the result of economic clouds looming on the horizon. Interest rates are complicated AND IMPORTANT. So, for my stock lovers out there, don’t lose focus on the bond market just because the Fed has switched to its softer cheek.
YESTERDAY’S MARKETS
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