It seems the general consensus is that interest rates are going to drop “because of some Federal program” or, “because the Feds are going to make them go down to boost the economy.” It seems we have more believers in and fans of central planning than I ever imagined. Let’s make one thing clear, interest rates in the long run, are controlled by the marketplace. The Feds cannot decree 3% rates for the next 5 years while we work through this economic mess. Even the Feds ultimately cannot control the marketplace. However, the Feds can impact interest rates in the short run with monetary policy decisions, and the purchase of mortgage backed securities. Ultimately the marketplace sets interest rates after taking into account inflation and deflation, government monetary policy, supply of and demand for funds, and future economic expectations.
It has also recently been discussed that the cost of funds is much higher for lenders, and the availability of credit to then turn around and extend to the public is diminishing. Hence, it is said that it is hard for banks to drop rates, regardless of what the Feds do, in light of less available and more costly sources of funds.
Mortgage Backed Securites (MBS) are pools of loans packaged together by Fannie Mae and Freddie Mac to be sold as investments. Once the loans are packaged together they resemble any other bond-like instruments. The price is the cost of buying that bond. The yield is the return on investment that you receive.
How may the Feds reduce rates in the short run? With MBS, just like a bond, the higher the price the lower the yield. Think of it as a teeter-totter, if one side is high, the other side must be low. If demand is high, prices rise. If many people want what you have, you can sell it for a higher amount. So, as the Fed buys MBS, prices rise. Now go back to the teeter-totter reference, if prices rise, yields (interest rates) fall.
However, the marketplace, which is much larger than any government, waits in the wings. And the marketplace is watching things like:
-Ludicrous government spending and debt issuance that is not supportable by revenues.
-China’s rhetoric against our debt levels and fear of U.S. default are rising.
-Trade war fears and the resulting retaliation.
-Foreign countries that used to finance our deficit now find that they have their own domestic ills to use their resources for.
-It appears the U.S. will have a harder time funding its deficit and planned spending.
-We have not even taken into account the amounts we owe for Social Security and Medicare, which dwarf our current account deficit.
My contention is that it does not matter how much MBS the U.S. government buys to try and keep rates down, we have bigger issues that will dwarf that attempt at reducing rates, and interest rates will rise, possibly sharply. The resources of the U.S. government are limited (you cannot tax and spend forever, the market stops you at some point), and their revenues are declining thanks to the weak economy. So we have only a handful of outcomes:
-Much higher taxes over a significant period of time to get more revenue for government.
-Higher interest rates due to higher demand for money pressured by lesser availability.
-Or, government drastically reduces its size and scope, hence it wouldn’t need to raise taxes, and as the deficit fell thanks to a drastically smaller government, rates would fall.
I think we all know the third outcome is highly unlikely. Our government has not cut a program or reduced its size and scope ever, in its entire history. We have been on an embarrassing and bloated increase in all that government meddles in since its inception. That is probably a separate blog post, really even a whole book, about the cost of ever expanding government and how that causes rates to be artificially and continually high. So there you have it, rates should likely rise, it just seems to be a matter of when, and by how much.