Recs

5

Will Rate Cuts Kill the Housing Market?

The latest rate cut from the Federal Reserve was again good news for the stock market. Unlike the last several Fed moves, however, this one didn't make mortgage borrowers cheer.

The Fed has cut interest rates quickly and dramatically in recent months, and the entire yield curve has responded. Although the interest rates that the Fed controls are all short-term rates, the rest of the bond market followed suit as yields fell across the board. As a result, mortgage rates fell, and homebuyers seeking mortgages benefited greatly.

This time, however, it's different. Although the Fed cut knocked another 0.5% off short-term rates, interest on fixed mortgages actually rose last week after the announcement, making it harder for potential buyers to afford to buy a home. And even if the Fed keeps cutting, there's no guarantee that any further action won't actually be counterproductive -- at least as far as the housing market is concerned.

Is inflation back?
The apparent disconnect between short-term and long-term interest rates actually reflects the relative importance of the factors that affect the bond market. Short-term rates are governed mostly by immediately prospects for economic growth. So as the economy slows down and the odds of a recession increase, short-term rates have dropped in anticipation of Fed moves and slowing demand for credit.

Those who look at long-term rates, on the other hand, take a much broader view of the economy. Most slowdowns and recessions last only a year or two, so for someone holding a bond that may not mature for 20 or 30 years, those downturns are just blips in the overall economic cycle. More important, however, are inflation expectations. As prices for staples like oil and food have remained stubbornly high, some are concerned that consumers may soon face higher costs for other goods and services.

Getting back to normal
The rise in longer-term interest rates means that those seeking a new mortgage may not get the lowest rates they might have hoped for. But the recent moves actually re-establish a normal pattern in the bond market, where investors are rewarded with higher rates by committing their money for longer periods of time. Unfortunately for savers, the normal-sloping yield curve came back mostly because of the huge drops on short-maturity bonds, which will reduce their income.

However, the normal-sloping yield curve is excellent for financial institutions. Banks rely on being able to obtain money from their depositors at lower rates than they receive from borrowers. Much of the money banks take on deposit are in accounts where customers can demand their money at any time or in short-term CDs, while the loans they make to borrowers are for longer periods. When the upward-sloping yield curve allows banks to charge more interest for long-term loans, it's reflected in better interest margins and profits. In large part, that's what's responsible for the huge rises in bank shares lately:

Stock

Change Since Jan. 18

Citigroup (NYSE: C  )

23%

Washington Mutual (NYSE: WM  )

62%

Wells Fargo (NYSE: WFC  )

32%

Irwin Financial (NYSE: IFC  )

78%

Hudson City Bancorp (Nasdaq: HCBK  )

18%

Banks both big and small have jumped on hopes that the red ink will stop here as most financials report large fourth-quarter losses that reflect mortgage-related writedowns.

It would be ironic if the Fed's actions to try to stimulate the economy and prevent a catastrophic failure in the financial markets actually turned out to stifle a recovery. Rallies in major homebuilders Toll Brothers (NYSE: TOL  ) and D.R. Horton (NYSE: DHI  ) suggest that the industry isn't worried yet. But if rate cuts continue and the mortgage market doesn't cooperate, those higher stock prices could evaporate in a hurry -- and you might miss out on the lowest mortgage rates in a generation.

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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