3 Reasons Why Mortgage Rates May Fall in May

Last week, the Federal Reserve lowered the Fed Funds Rate by a quarter-percent but it wasn't the Fed's actions that mattered most to markets.  It was what the Fed said that did.

In its press release, Ben Bernanke & Co. specifically mentioned that:

• The U.S. economy is stabilizing over the near-term
• Inflationary threats are diminishing over the medium-term

If you are shopping for a mortgage and don't live outside the circle, the after-shocks of the Fed's press release may be the best news you hear all day. 

Just kidding.  It won't.  Just kidding.  It will.  Just kidding.  Just kidding.  Just kidding.

Markets are interpreting the Fed's press release to mean that the rate-cutting cycle that dropped the Fed Funds Rate to its lowest level since 2004 is over -- at least temporarily.   This belief that the Fed is on "pause" is helping the U.S. Dollar to rally. 

An improving dollar is a big deal for two reasons right now:

1. Crude oil is priced in dollars
2. Mortgage bonds are priced in dollars

Let's look at crude oil first. 

When you and I go to gas stations for fill-ups, 59 percent of what we pay is based on the price of crude oil.  Naturally, as the price of crude oil has escalated, our gas receipts have, too.

Since last year at this time, crude prices are up about 75 percent.  Part of the increase is from Supply and Demand forces, but part of it is related to the falling U.S. dollar.

If market forces say that crude oil should cost $100 per barrel but those one hundred dollars are losing their value day-after-day, the sellers of crude oil will demand a premium.  The one-hundred-dollar barrel, therefore, may have to sell for $101.

As the dollar lost value during the rate-cutting cycle, the crude oil premium increased.  This is one reason why gas prices have constantly ticked higher -- investors believe(d) the dollar had further to fall.

After the Fed's announcement, though, the dollar regained some of its lost ground and crude prices fell.  In a related story, gas prices retreated Friday in Cincinnati, Chicago and elsewhere for the first time in 18 record-setting days.

This is noteworthy because rising energy prices was one of the economic threats specifically fingered by the Federal Reserve in its statement:

"Energy and other commodity prices have increased", its statement said, and "uncertainty about inflation remains high."

If oil prices fall because the dollar is strengthening, inflation pressures should start to subside.  That would give mortgage rates another reason to fall.  If inflation is the enemy of mortgage rates, the absence of inflation must be its friend.

In addition to lower crude prices, a stronger U.S. Dollar could help boost demand for mortgage-backed bonds.  This would lower mortgage rates for Americans. 

From an investor's perspective, as the dollar increases in value, the monthly mortgage repayments on a mortgage are worth more to the person doing the collecting.  This is one reason why a rising dollar tends to increase demand for mortgage-backed bonds.

With more demand, the bonds' respective prices move higher and higher bond prices leads to lower bond yields, or lower rates.

This isn't a direct connection -- a strengthening dollar doesn't always lead to lower mortgage rates -- but in a vacuum, it does.  Dollar-denominated bonds are worth more as the dollar itself it worth more.

This is why the third connection is so important -- it's related to the Fed's supposed "pause". 

It's very easy for a rate-cutting Federal Reserve to over-stimulate the economy into inflation.  Low borrowing costs can induce over-investment and capital expenditure.  It's called the Fool in the Shower scenario that I love to talk about.

With the Fed expected to take a wait-and-see approach in the near-term, it reduces the possibility severity of rate-cut-induced inflation later in 2008. 

Again, the absence of inflation is good for mortgage rates.

The Fed doesn't officially meet again until the end of June but of the market speeds up or slows down too fast in the interim, expect it to step in and create new policy.

For now, though, economic optimism prevails, the dollar is gaining and mortgage rates should benefit.

(Image courtesy: Antiquark)