Fed funds rate and the treasury yield
I am having trouble understanding how the two relate and would love some guidance. At the most basic, I understand that the fed funds is an overnight rate (the most short-term) while treasury yields are longer term, depending on the security in question. Of course, the fed funds is something the government manipulates and the treasury yields are not. Googling this topic has brought up that they were historically connected but that connection seems much weaker recently. In my mind, I am thinking of it as: when fed funds is high, that means that economy has been doing well and the Fed is presumably putting on the brakes. When the economy is doing well, there is less interest in the safety of treasuries, and the yield subsequently goes up due to lack of demand. Would this line of reasoning be correct?
The reason I ask is the WSJ article on $362 billion of subprime resets in 2008. I had thought that the subprime mortgage rates were based on the fed funds rate, but I now think they are based on treasury yields. Obviously, if the two are strongly correlated, the recent rate cuts should help prevent some homeowners from defaulting.
Thanks for any help.
I didn't read the article, but the first thing to clarify is what you are calling "treasury yields." Go to bloomberg.com > Market Data > Rates & Bonds to see the yield curve. Treasury yields differ based on the maturity, from 3 months to 30 years. Mortgage rates are generally determined with the 10-year treasury as a base, I believe. Like many fixed income securities, the treasury yield (at the comparable maturity) is used as the base, and a spread is applied to compensate for the added risk.
From watching the effects of the cuts this year, you could argue that there is good correlation between the Fed Funds and short-term treasury yields. But since Fed Funds is short term rate, and 10-year is considered long term, many argue that cuts do not directly affect mortgage rates.
the fed funds cut doesn't really help out the people that are going to default, only NEW borrowers (and thats not certain). it does help out the banks that had repackaged the debt in cmo's thought. since the fed funds rate is the rate that banks have to pay the government for cash, it makes it "cheaper" for them to go this route to borrow money to soften their fall (they could presumably borrow at the fed funds rate and then reinvest without risk at the treasury yield, making risk-free cash).
lowering the rate also increases liquidity across the board a little (which I guess is OK for NEW mortgage borrowers, but when commercial banks clamp down due to pessimism, liquidity isn't really increased by the lowering of the rate, the fed can only lower the rate again as they did).
Why would the fed funds rate help new borrowers more than old? The resets aren't pre-determined, they are based on a certain bps spread above the rf rate.
Raising the fed funds rate reduces liquidity, which will eventually lead to an increase in the long-term rate. When the ARMs reset, they will reset according to the current rate, which may or may not be as low as they anticipated when they entered the original mortgage.
Let me know if I am just completely off base.
also>>>
http://rick.bookstaber.com/
check that out if you have time to do some reading. he does a pretty good job of explaining the subprime issues in some older posts.
Thanks guys. Even more than understanding subprime, I wanted to refresh (more like relearn) the stuff I learned in macroeconomics in college. When the media talks about currency, subprime, inflation, etc., I can follow the articles and discussions but I sometimes wonder how many people, especially those on Wall Street, can make all the links between one macroeconomic issue to another. For example, between money supply, interest rates, inflation, exchange rates, and overshooting.
bump. I'd also be very interested in having some info on how macroeconomic issues relate to one another. Any good sources out there? Thanks
http://economics.about.com/od/macroeconomics/Macroeconomics_Resources.h…
"the fed funds cut doesn't really help out the people that are going to default, only NEW borrowers (and thats not certain)."
depends on what the arm reset is based off of.
no you're right on if talking about arms. i was thinking of fixed-rate...
The "federal funds rate" is the rate banks charge EACH OTHER for overnight lending, in case some of them run low on reserves. It's a rate that's finely tuned, but not totally controlled, by the Fed. This means, the fed can only inject and train money from the system to "tune" the rate by the force of market power. It can't really "set" the rate at a give number, but rather a "target".
Then there's all those loans. A lot of them are based on the fed rate plus spread. But as the term of the loan increases, the rate is more and more related to inflation and future economic expectation other than short term liquidity cost. Inflation determines how much that money is gonna be worth in the future, and economic future accounts for opportunity cost. This makes sense. If you lend out an over night loan, you almost don't have to worry about inflation. But if you lend someone money for 30 years, you gotta seriously think about how much is that money gonna be worth when it's finally paid back.
Therefore, the influences of federal funds rate has on treasury and mortgage rate is much more complicated. A lower federal funds rate provides cheap liquidity, making it cheaper for banks to lend. At the same time, low short term rate increases future inflation pressure, so banks might have to charge more. Also when federal funds rate is low the economy tends to boom and stock market will go up. That also accounts for banks' opportunity cost.
Over all it's a very complicated issue.
Fed Funds Rate and Treasury Yields (Originally Posted: 10/08/2015)
Hey all,
How does the fed funds rate affect treasury yields? The correlation between 10 year treasury yields and the fed funds rate is high, but why is that the case?
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