Trump, Merkel and the Weather…They Can All Affect Interest Rates. Really?
When lenders set their interest rates each and every day, to the average consumer it might appear there is no rhyme nor reason as rates seem to vary just a bit over time. Sometimes the variances are minor and sometimes they’re nothing of the sort. But lenders do have a system and all mortgage companies follow its own internal process. Interest rates are either fixed or variable. For fixed rates, lenders refer to a specific mortgage bond or mortgage-backed security.
For a 30 year fixed rate, lenders track what is known to in trading circles as the FNMA 30 yr 3.5 coupon. Investors buy and sell these bonds throughout the day and in exchanges all around the world. For a 15 year fixed, the bond is the FNMA 15 yr 3.0. Freddie Mac also has its own index investors track. So too do government-backed loans of VA, FHA and USDA programs have their own set of indices. Adjustable rate loans are tied to yet another index with perhaps the most common index used today is the LIBOR, or London Interbank Offered Rate or the 1 Year Constant Maturity Treasury, or CMT. Lenders follow these indices, add a margin to the index and set their rates for their various adjustable rate mortgage programs. But what makes these indices and therefore interest rates move?
Because fixed rates are tied to a specific bond they also act like any other bond. When the price of a bond goes up, the yield, or rate, falls. When an investor buys a bond the end profit is known in advance. There is relatively little risk when investors purchase bonds yet at the same time the returns are low. So why do investors put their money in a vehicle where they know they’re not going to make very much on the investment? Security. Bonds provide a safe haven for investors. Investors don’t put all their money in one investment but instead spread it around. Mutual funds follow the same philosophy. In order to lessen the amount of risk in any specific portfolio, funds are placed in investments with varying degrees of risk. Investors can “hit a home run” when speculating on a particular investment but at the same time they can lose money on another. With bonds, that risk is alleviated in exchange for a smaller payout.
When investors are confident about future economic performance of any sector they tend to place more funds in stocks and less money in bonds. They want to take advantage of a growing economy but at the same time protect a certain amount in the safe haven bonds offer. When they pull money out of bonds in order to invest in stocks, they must sell those bonds and when there is little appetite for bonds due to the growing economy investors must lower the price to find buyers. And just as higher bond prices mean lower rates, lower bond prices mean higher rates.
If investors see an economic slowdown coming or interpret the latest Federal Reserve Board comments that a slowdown is ahead, in turn investors can sell stocks and put money into bonds once again. This is a never-ending cycle and it primarily has to do with expectations.
But there are other, external forces that can shake things up that an investor isn’t prepared for. What sort of things? Political events can do that. So can natural disasters like hurricanes and earthquakes. How so?
Think again for a moment why investors buy bonds even though the yields are low. Safety. In uncertain times or when the crystal ball suddenly isn’t so clear, bonds are bought, boosting prices. For example, let’s say President Trump makes an announcement that suggests armed conflict is on the horizon. Such an event could rattle Wall Street as geopolticial affairs could cause consumers to pull back on their spending and instead keep money in a savings account. The economy counts on consumer spending to keep the economic engine going. But if investors see consumers slowing down their buying or a report is released showing consumer sentiment about the economy is faltering, stocks sell off and money goes back into bonds.
And it’s not just political events here in the United States. Investors like stability. They like to know they’ve got things planned out. But not too long ago, Britain announced it was leaving the European Union. The process is still underway and if all goes according to the schedule Britain will exit the EU on March 29, 2019. When it was first announced, investors across the globe were not only surprised but they took defensive actions and sought a flight to safety. This often meant bonds.
The weather? Oddly enough natural disasters can have an effect on interest rates. For example, when a major hurricane such as Hurricane Harvey hits, the rebuilding process is massive. To rebuild, banks will make loans and as the demand for money increases so too can interest rates. Banks do not have an endless supply of funds. When there isn’t enough money available from banks, FEMA steps in and the federal government, or more specifically you and me, picks up the bill. A new demand for supplies including food and water can also cause prices to rise and inflation can enter the picture. Beyond the physical damage natural disasters cause, there is also longer term economic damage.
Investors spend a lot of time researching trends and economic models as they determine how to allocate their investment funds. Yet there are external forces they cannot predict and when they happen, rates can immediately take a hit. And, after a few days when it’s determined the event was short-lived and there is no future threat, markets return to normal trading.