Fed? What Fed? Mortgage rates fall

Mortgage rates don't always move in the direction you expect them to. Such is the case this week, when the Federal Reserve raised short-term interest rates, and long-term mortgage rates headed the opposite way.

The benchmark 30-year fixed-rate mortgage fell 5 basis points, to 6.34 percent, according to the Bankrate.com national survey of large lenders. A basis point is one-hundredth of 1 percentage point. The mortgages in this week's survey had an average total of 0.39 discount and origination points. One year ago, the mortgage index was 5.69 percent, and four weeks ago it was 6.42 percent.

The 15-year fixed-rate mortgage fell 3 basis points to 5.92 percent. The 5/1 adjustable-rate mortgage fell 1 basis point to 5.88 percent.

Mortgage rates tend to be buffeted by the same economic winds that move yields on U.S. Treasury notes. Treasury yields hadn't moved much in the week before the Fed's rate-policy meeting. On Tuesday the Fed raised the federal funds rate by a quarter of a percentage point, to 4.25 percent.

Fed omits the 'A' word
Everyone expected the rate raise. The real news lay in what the central bank had to say about the pace it anticipates rates to change in the economy's next phase. The upshot: The Fed's hikes will soon halt; interest rates are near their top because consumer costs are hardly rising.

The market came to this conclusion because of what the Fed did not say and what the Fed did say. For the first time in many months, the central bank did not use the word "accommodative" to describe interest rate policy. By taking out that word, the central bank was implying that interest rates are no longer stimulating the economy too much. Instead, the Fed implied, rates are close to, but not yet at, a point where they're neither pushing the economy too fast, nor thwarting it.

That's what the Fed meant when it said, in its post-meeting statement: "some further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance."

Bond traders interpreted that to mean that the Fed will raise short-term rates at least one more time, on Jan. 31. An increase at the meeting after that, in March, is possible if inflation ticks up. Bottom line: The bond market thinks the federal funds rate will peak at 4.5 or 4.75 percent.

"I think the bond market had been worried that the Fed might want to push up rates to 5 percent eventually," says Stephen Buser, finance professor emeritus at the Ohio State University. But now, "most people are expecting maybe one more increase and then maybe the Fed will stand back."

The end is near
That word from the Fed comes as a minor surprise. Bond traders had been expecting the Fed to raise short-term rates to 5 percent, and now it looks like the central bank will stop short of that, so current long-term rates and bond yields fell back a little.

Buser draws an analogy between what the bond market did this week and what sports bettors do. If a football team is favored by 10 points, and then a key player is injured in practice, the team might remain favored, but by only 5 points instead of 10. In the case of bond yields, traders had expected the Fed to top out at 5 percent, and now they think the Fed will end up at 4.5 or 4.75 percent. Since current bond yields reflect traders' expectations about the direction of future bond yields, the current yields fell.

It's a tough concept to grasp and even harder to explain. It all boils down to expectations: The Fed has led bond traders to believe that rates won't rise as far as traders had feared. Long-term rates fell because those higher-rate expectations had been built in.