Interest Rate Mystery: Fed Cuts, Yet Mortgage Rates Climb

Some of the greatest financial minds of our time are puzzled by the fact that, in recent years, mortgage rates have failed to follow Fed rate cuts. The odd and paradoxical divergence is largely unexplained, but is attributed to the fact that we're in a new global economic frontier.

During the official tenure of former Federal Reserve Chairman Alan Greenspan, the Fed hiked the federal funds rate from 1 percent to 5.25 percent, and everyone expected long-term rates on 30-year mortgages to rise in lockstep fashion. Instead, they fell-to the surprise and befuddlement of economists. Greenspan was asked by Congress to explain the aberration and he said, "the broadly unanticipated behavior of world bond markets remains a conundrum."
    

Mortgage rates out of whack

They say that those who don't learn from history are condemned to repeat it, and perhaps economists who didn't figure out how to solve the Fed rate versus mortgage rate enigma back in 2005 are being forced to revisit it now in 2008.  Traditionally, mortgage rates worked this way: when yields on 10-year Treasury notes went up, so did 30-year mortgage rates. Conversely, when 10-year Treasury yields fell, mortgages got cheaper. But now, the divergence first noted by Greenspan is back in a different form, even though no one can explain why.

Consider, for example, that a year ago, fixed mortgage rates on 30-year loans averaged 6.66 percent, while the 10-year Treasury notes offered investors yields of 4.85 percent. Now, those mortgage rates still hover around the 6.66 mark, but yields on 10-year Treasury notes have slumped to 3.79 percent. Using history as a benchmark, these numbers don't make sense. But some of the smartest economists agree that old paradigms are now obsolete because of marked anomalies such as these:

• Mortgage problems are normally preceded by devaluation of equity due to slowdown in demand for houses.  But the current crisis was primarily fueled not by diminished demand for homes, but by subprime mortgage lenders acting in cahoots with Wall Street speculators.

• The most rich and powerful nations in the world usually control global monetary developments. Today, two of the poorest nations, India and China, are having a profound effect on the superpower country economies.

We live in a new financial frontier. Fed rates and mortgage rates are acting strangely, but global financial markets are undergoing unprecedented transformation. Not knowing what behavior to expect from mortgage rates means that it's impossible to quantify risk.  That scares the daylights out of investors who always retreat in fear when the markets behave in unpredictable ways. Rapid change makes people nervous, and until stability returns-even if it means a whole new way of looking at world economics-investors will have the jitters, and their indecisiveness will express itself as bizarre interest rate behavior.