HOW LONG WILL RATES BE SO LOW?

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On March 15, 2020, in the wake of the coronavirus pandemic, the Federal Reserve cut the Fed funds rate to 0.25%. This reflects the rate at which commercial banks lend reserves to each other overnight, on an uncollateralized basis. The Fed’s goal is to encourage growth and spending. As the pandemic continued, the Fed maintained the target rate on June 10, 2020. Faced with increased unemployment and business closures, it is unlikely the Fed will raise rates during its July 28-29 meeting.
Discount Window
The Fed also cut the rate of emergency lending at the discount window for banks to 0.25% and extended the loan terms to 90 days. The discount window plays a crucial role in supporting liquidity and stability of the banking system. It supports the flow of credit to both households and businesses. The discount window is part of the Feds as the “lender of last resort” to financial institutions. Its presence is to support the bank’s liquidity needs. Banks generally reserve the option for extreme situations—exercising the right to borrow from the Fed can be an indication of financial distress.
Quantitative Easing
The Fed continues to make monetary moves to mitigate the economic turmoil caused by the pandemic. Pulling from its tactical bag of tricks, quantitative easing is being employed to purchase longer-term government bonds and mortgage-backed securities. Purchasing securities increase the domestic money supply and lower rates by bidding up fixed-income securities. This measure is meant to lower borrowing costs and expands the central bank’s balance sheet.
Mortgage Rates
Mortgage rates will continue to remain low because of the low 10-year Treasury rate. There is a strong correlation between mortgage interest rates and Treasury yield. Coupled with the Federal Reserve lowering the target for the Fed funds rate to close to zero on March 15, 2020, mortgage rates will continue to remain below historical levels for some time.
Average 30-year fixed rates, according to the Freddie Mac Primary Mortgage Market Survey, have been below 3.25% since the third week of May. For the week of July 9, the survey reported a historic low of 3.03% with 0.8 fees and points. Rates in the market have not fallen as much as anticipated, largely due to the heavy demand for refinancing. Lenders get higher than typical margins on loans when demand is strong. Mortgage banks and companies are at liberty to set the rates to consumers. Banks and mortgage companies are also tightening credit standards in an attempt to hedge against borrowers losing their jobs and requesting forbearance.
According to the Mortgage Banker Association’s Market Composite Index, mortgage applications are up 33% year over year for the week ending July 3, 2020. The Refinance Index is 111% higher than the same period one year prior. The market is largely recovered from the brief COVID-19 induced pause of spring and summer, and the rest of 2020 is on course for strong purchase and refinance activity.
Prime Lending Rate
In July, the prime lending rate is a low 3.25%, down 2.25% from the same time a year ago. This is reducing the cost to borrow for consumers. Auto loans, credit cards, home equity lines of credit and other short-term loan products are based on this rate. Banks use the prime rate, plus a certain percentage to calculate the loan rate, based on the borrower’s financial stability, credit score, and other factors.
Automakers chose to embrace the pandemic as a way to boost sales. Zero percent car deals, payment deferrals, and incentives emerged in the spring and early summer along with contactless purchases. Although these deals seem attractive, with the economy as unstable as it is, there is the potential for future job loss and auto loan defaults. Lenders allowing 90-day payment deferrals at purchase cause consumers to pay more over the life of the loan. Also, with long-term car loans, borrowers are more likely to be underwater a good portion of the loan term.
Auto loan delinquencies hit a nearly 5% past due in fourth quarter 2019, the highest 90 delinquency rate in seven years. Subprime auto lending has been on the rise for a few years. Performance on auto loans improved in the first quarter of 2020 but $7.8 billion in loans received forbearance in April, according to S&P Global Ratings. Car values are tied to supply, and an increase in defaults may further suppress vehicle values, especially in the event of repossession and auctioning of bank-owned vehicles.
Banks are tightening credit standards for auto lending. As of May, more than 60% of originations were extended to borrowers with a credit score of 700 or higher. With forbearance policies and unemployment benefits, analysts forecast auto delinquencies may not rise until the third quarter of 2020. S&P placed 33 subprime ABS deals on Credit Watch with negative outlooks in May, an indication of a potential downgrade if delinquency rating increases.
Credit card issuers are offering attractive zero percent introductory offers and balance rate transfers, looking to retain customers and attract new ones. The Fed reported the average interest rate on credit cards was 14.52% in May, as opposed to 15.09% in February.
In 2019, consumers were confident and using credit. For the final quarter of 2019, credit card debt balances rose to $930 billion. By February, credit card balances exceeded $1 trillion for the first time in almost three years. The economy was strong, and Americans were spending and carrying balances.
The pandemic has had a surprising effect on revolving debt. Consumer’s outstanding balances dropped by $24.3 billion in May, leaving $995.6 billion outstanding, according to the Federal Reserve. Sequestered at home, consumers spent less on credit than before the crisis. The Federal Reserve Bank of New York’s survey of consumer expectations released in June reported that consumers were more optimistic about making debt payments than they were in the April survey.
So How Low, How Long?
The Federal Reserve will be watching the domestic and global economy closely. The Fed’s mandate is to use monetary policy to attain the maximum sustainable rate of employment, price stability, and moderate long-term interest rates.
Inflation is not currently a concern, but if growth is too rapid, the Fed will raise rates to temper price increases and stave off inflation. During economic downturns, the Fed stimulates economic growth by keeping rates low and financing “cheap” for businesses and consumers.
Capital investment is necessary to spur businesses to hire, invest, and expand. While rates are low for consumers, big-ticket items like cars and homes are more affordable. Consumers move from renters to homeowners, from smaller houses to bigger ones; they start families and transition from cars to minivans or SUVs. This also fuels the secondary and debt markets. Household formation and expanding families spur spending. The delayed reopening of the country will have a lasting economic impact on consumers and businesses. The recovery is highly dependent on employment and business growth. So, for the second half of 2020 and 2021, rates will remain historically low. The Fed will wait to see whether its measures help the economy recover from this health and financial crisis.
Amie McCarthy has more than two decades of experience in mortgage finance, structured products, and banking. She is a vice president with Nationwide Title Clearing, covering capital markets. McCarthy has worked from Wall Street to Washington, D.C., for investment banks, a GSE, and regulator. You can reach her at Amie_McCarthy@nwtc.com

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