When you are in the mortgage industry, everyone seems to ask “Where are mortgage rates going?” It’s a good question, but if any mortgage originator worth their salt actually knew what drives interest rates (or more importantly, where they were going next) then they wouldn’t be a mortgage originator. They would be a billionaire sitting on a tropical beach drinking mai tais. Ah, yes.
Tropical beaches are nice!
Oh. Back to reality. Sure, no one knows for sure, but surely there is someone who knows what drives interest rates, right? Well, to some degree, yes. The fundamental factor is actually not very complicated.
C’mon, what drives interest rates?
You have no doubt heard that the three most important factors in real estate are location, location and location. Well, the three most important factors in interest rates are inflation, inflation and inflation.
Why is this? The easiest way to understand this principle is with a simple illustration.
Let’s say that I have $100 that I’m thinking of spending on a nice steak dinner. Just before I go out the door my friend David calls and says he desperately needs to borrow $100. Can I help? He’ll pay me 5% interest and pay it back in one lump sum one year from now. So, in a year, he’ll pay me $105.
A steak dinner drives interest rates? How?
I like David, but I love steak dinners. I also know the value of letting your money work for you. If I defer enjoying my steak dinner for a year, I can have the steak dinner and $5 too. Or can I?
What if the price of the steak dinner goes up by $5 in the next year because of inflation? Then next year when David pays me back all I can do with the $105 is buy the same steak dinner I could enjoy tonight. I’ve really made nothing at all, and I’ve delayed enjoying my steak dinner for a year.
So, if my motivation is to earn money on my money so that I can buy even more steak dinners, I have to charge David more than what inflation will eat up for as long as he controls my money. If I believe that inflation will be 5% over the next year, will I accept 5% return on my investment? No. How about 4%? Definitely not. Would I accept 6%? Maybe, but making $1 in buying power doesn’t seem attractive. The final answer will depend on the investor (and what the investor thinks inflation will do over the next year,) but for sure it will be more than the generally accepted projection of inflation.
So, inflation is what drives interest rates? They track the CPI?
There’s the rub. If it were merely about inflation, we could just look at the Consumer Price Index (CPI) which attempts to measure recent inflation levels, but investors are more concerned about future levels than the past, aren’t they?
Predicting Inflation Trends
Institutional investors who move billions of dollars a day look at every possible factor to try to guess where inflation is going. What do they look at?
Inflation tends to accelerate when the economy is growing too fast. Many factors drive this. When manufacturers are busy they may have to compete with each other for the raw goods needed to make whatever they make. The price of those raw goods rises because of demand, thereby raising the production costs of the finished products. More energy is consumed to manufacture and deliver goods and services, and so the price of this goes up, too.
If companies are doing well and hiring they may have to compete for good employees, which drives up wages, especially if we are at low unemployment. With higher production costs manufacturers will have to raise their prices, and with higher wages consumers will be able (and willing) to pay the higher price.
So, is inflation or economic growth what drives interest rates?
Well, economic growth drives inflation, and inflation is what drives interest rates, so, yes.
Institutional investors, therefore, read economic reports and the opinions of the smarter and more reliable economists to try to divine what inflation is expected to do for the time period over which they are investing money. Are auto sales up? That could send inflation upward. Are unemployment claims up? That could be a sign that the economy is slowing down and could be good for interest rates.
If you want to know which economic reports are likely to be significant in the coming week or so, simply do an internet search for “economic reports” and look at what upcoming economic reports financial writers think are important.
The golden rule says that he who has the gold makes the rules, and that is pretty much true in this case. It is at least true that those who have money and want to put it into investments that are used to make loans (say, mortgages) are the ones who decide what yield they need to make. They base their desired yield on what drives interest rates – their expectations of inflation.
So, the next time you want to ask a mortgage originator where interest rates are going to be a year from now, recognize that he or she is not sitting on a tropical beach drinking mai tais, and therefore really has no idea. Instead, ask them if they know what drives interest rates, and if they can’t tell you, now you can tell them.
This article represents the opinions of Casey Fleming, and not necessarily those of C2 Financial Corp. This analysis was prepared with the best information available at the time it was written. Neither Casey Fleming, nor C2 Financial Corp., have any magical insider information about bond markets, real estate markets or mortgage markets that would make economic projections any more reliable than any other source. No warranty is made that the outcome will reflect the projections in this article, and neither Casey Fleming nor C2 Financial Corp. are responsible for decisions that you make regarding your own choices about your real estate or mortgage or those of your clients.
Fair use and redistribution
This article is copyrighted and may not be used or reprinted without permission. However, we encourage you and freely grant you permission to reuse, host, or repost this article and any images used therein, provided that when doing so, you attribute the authors by linking to LoanGuide.com or this page, so that your readers can learn more about this topic. Your link must be a “dofollow” link.
For any other use, please contact us at LoanGuide@Outlook.com.