Federal Reserve, Bonds, and Mortgate Rates

This week the Federal Reserve started buying long term treasury bonds in an effort to lower mortgage rates and provide stimulus to the economy by having home owners refinance mortgages and have a lower monthly mortgage payment. The strategy is to create more demand for these bonds and increase the price of these bonds which would lower the interest rate. This strategy did not work and provides a good indicator for an investor. Let me explain this in more detail.

First, mortgage rates are linked to treasury bond rates in the following manner. For example, Wells Fargo offers a 15 year mortgage at a 4.625% interest rate to anyone who qualifies. They buy the amount of 15 year treasury bonds in proportion to the amount of the mortgage at a much lower rate, currently about 3%. Money is made by Wells Fargo on the interest rate spread of 1.625%.

Second, interest rates and bond prices on long term bonds go in the opposite direction. The reason is that a bond is purchased at a lower initial purchase price than the value of the bond and full value is achieved when the bond is held to maturity. For example, a 10 year bond with a value of $1,000 is purchased for about $500 and yields an interest rate of about 7%. If the price of the bond increases to $750 the resulting interest rate is about 3.5%. As the price of the bond goes up and down, and the investor gets the resulting lower or higher interest rate.

Third, from a supply and demand perspective the price of anything goes up as demand goes up or supply goes down. Conversely, the price of anything goes down as demand goes down or supply goes up. As we know from the previous paragraph, as demand for bonds goes up the purchase price goes up resulting in a lower interest rate.

This week the Federal Reserve started buying $300 Billion worth of long term bonds in the open market. Since no additional bonds were issued, the price of the bonds should have gone up lowering the resulting interest rates. What actually happened was exactly the opposite, the price of the bonds dropped resulting in increasing interest rates.

What this means is that more investors are selling their bonds than being bought by the Federal Reserve. When investors start selling long term bonds it is an indicator of future inflation and higher interest rates. As an investor, you do not want to follow the direction of US government, you do not want to own long term bonds.

When interest rates are going up it is positive for investors who purchase short term bonds or stocks. A risk averse investor would purchase CDs or Money Market funds. A risk taking investor would purchase stock. An investor can do better by watching interest rates rather than financial experts on TV.