A common misconception, even amongst mortgage brokers and lenders, is that mortgage rates are tied to the 30-year treasury bonds or 10-year treasury notes. When in reality, these are government-backed securities with no direct effect on mortgage rates.

Mortgage rates follow what is known as mortgage backed securities (MBS). These are bonds issued by Fannie Mae and Freddie Mac – in which the trading performance of these instruments determines the direction of mortgage rates. Moreover, the relationship between bonds and interest rates is inversely related. Thus as bond prices rise, interest rates fall, and as bond prices fall, interest rates rise.

There are many different factors that impact the purchase and sale of mortgage-backed securities, but generally speaking, the bond market is reactive to economic news more than anything.

• Inflation – This has a negative effect on any type of long-term bond. Since bonds pay out a set amount over a long period of time, eventually that amount becomes less valuable as inflation increases.
• Economic Indicators – There are over 30 economic reports that come out on a weekly, monthly quarterly, and annually basis that impact the marketplace. Reports such as retail sales and unemployment can have a strong impact on the bond market. Typically, anything that suggests a growing economy, or inflation, has a negative impact on the bond market.
• Stock Prices – Over the past several years, the bond market has shown an inverse correlation to the stock market. As the NASDAQ moved higher, bond prices moved lower, causing interest rates to rise and vice versa. However, more recently, inflationary fears have caused a decrease in both stock and bond prices, with more people moving to a cash position.

Contrary to what most believe, the Fed rate cuts have little direct effect on mortgage rates. It’s not what the Fed does that affects mortgage rates so much as how the stock market interprets the Fed’s action that ultimately influences the direction of mortgage rates. Money managers and mutual fund companies typically keep funds in either stocks or bonds with very little in cash, thus when stocks are favored, money is typically pulled from bonds causing bond prices to drop and interest rates to rise; when stocks are being sold off, the money is then parked into bonds, which improve bond prices and causes interest rates to decline.