He said / he said

A buddy of mine likes to call me 'Chicken Little' with all my talk about the threat of rising interests rates.

And with his latest email taunt he sends along this news item from last Thursday in which US Federal Reserve Chairman Ben Bernanke restated his observation that low inflation and a sluggish economy are “likely to warrant exceptionally low levels of the federal funds rate for an extended period".

Then my friend points an accusatory finger at last Monday's post in which I used the image of a dead canary in a coal mine to illustrate the looming threat of interest rates. This, he says, is my most recent example of 'irrational fearmongering'.

Irrational fearmongering?

Hmmm... we'll come back to that thought in a moment.

For now let's focus on what Bernanke said.

The Federal Reserve Chairman reiterated his position that "the federal funds rate" is likely to remain exceptionally low for an extended period.

A great many people assume that this will mean mortgage rates in the United States (and by extension, Canada) will also remain exceptionally low for an extended period of time.

Not true.

In the United States, the federal funds rate is the interest rate at which private depository institutions (mostly banks) lend balances (federal funds) at the Federal Reserve to other depository institutions, usually overnight. It is the interest rate banks charge each other for loans.

This has a direct impact on what your rate for borrowing will be, but it's important to note that it is not the determining factor on what interest rates will be for mortgages.

Mortgage rates are determined by Mortgage Bonds or Mortgage Backed Securities. As these items trade, the yields produced cause mortgage rates to fluctuate. In fact, it is not unusual to see them move in completely different directions than the Federal Funds rate.

[Note: the US Federal Reserve has been involved in an unprecedented program over the last year where they have been buying up Mortgage Backed Securities. Their willingness to purchase this debt - at low yields - is what has been keeping long term mortgage rates exceptionally low. The US Federal Reserve now 'owns' 10% of all US mortgages and there is tremendous concern what will happen when the program ends and they cease artificially supressing the mortgage rate)]

When the Fed lowers the short-term Federal Funds discount rate, this is designed to stimulate consumer spending on short-term credit, which affects credit card rates, some car loans and lines of credit. The short-term discount rate has little affect on long-term mortgage rates.

When the Fed cuts the rates, especially by a large or repeated percentage-point drop, people automatically assume that mortgage rates will fall. But if you follow mortgage rates, you will see that most of the time the rates fall very slowly, if at all. Historically, when the Feds have dramatically cut rates, interest rates remain almost identical to the rates established months before the cut as they do months after the cut.

Often what happens in the market is that investors spot a short-term stimulus (usually government stimulus) and they bail out of the safe haven of bonds (or mortgage backed securities) and move those dollars into stocks.

When this happens, we see a rally in the stock market and a sell-off of mortgage backed securities, both of which cause interest rates to go up.

It's the yields on these bonds that are important. When they cannot be sold, the yield has to go up to attract investors. And when the yield goes up - so does the mortgage rate.

That's why, on the day after Bernanke's comments, former Fed Chairman Alan Greenspan is making news and raining on his buddy Bernanke.

Greenspan claims the recent rise in Treasury yields represents a “canary in the mine” that may signal further gains in interest rates.

Canary in the mine?. Mr Greenspan, do tell.

Bloomberg reported the story and quoted a TV interview they conducted with Greenspan.

"Higher yields reflect investor concerns over this huge overhang of federal debt which we have never seen before. I’m very much concerned about the fiscal situation,” said Greenspan. These comments were made while discussing the trend towards an increase in long-term interest rates.

Last Monday I used the analogy that the rise in Treasury yields represented the stereotypical 'canary in the coal mine' alarm for interest rates. And by the end of the week, Alan Greenspan was saying exactly the same thing.

Neither of us considered Bernanke's comments about the Federal Funds Rate relative.

Nor should you.

Perhaps we should term it... 'rational' fearmongering.

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