The Day of Reckoning Beckons 

By the end of Thursday we'll know: Will the Federal Reserve have raised its target range for the federal funds rate, or will it have once again kicked the can down the road? 

As of Wednesday, the folks who put money on the line are betting a 23% chance that a higher fed funds rate will prevail. This is according to CME Group, which monitors trader action in the federal funds rate futures market. Of course, these same traders were betting a 19% chance last week and a 32% chance the week before that. These traders are a fickle lot. As the stock market goes, so seems to go their sentiment on the fed funds rate. 

It's all scuttlebutt, really, and scuttlebutt on the Fed and the fed funds rate is similar to scuttlebutt on the weather: There's a lot you can say, but not much you can do. You have to live with what you get. 

As for us, we still think we'll get another kick of the can. The target rate will remain as is – between 0% and 0.25%. This is where the fed funds rate has been firmly ensconced for the past six years. The rationale for our prognostication remains unchanged: low inflation, stagnating global economic growth, an unstable stock market, a strong U.S. dollar.

But what if we're wrong? What will happen to mortgage lending rates if the Fed moves to raise its target on the fed funds rate? 

The fed funds rate is a short-term rate. Indeed, it's a very short-term rate: It's the overnight lending rate among commercial banks. If the fed funds rate rises, short-term rates will likely be impacted most, at least initially. This means 1-year and 5/1-year ARMs will likely adjust first. 

On the longer end, it's possible little will change immediately. Rates on the 15-year and 30-year loans tend to act more independently of the Fed. It's possible the fed funds rate could rise, and rates on the 15-year and 30-year loans will continue to hold current levels.

Inflation also favors longer-term rates holding steady. The latest data on the consumer price index (CPI) show prices actually fell 0.1% in August. The shift down was lead by a fall in oil and gasoline prices. Given the dearth of inflation, it's possible we could see the yield curve begin to flatten, or even invert. This means short-term rates could rise, while long-term rates do nothing. 

But as we say this, the yield on the 10-year U.S. Treasury note, which influences longer-term rates, is up 15 basis points this month. In the past week, rates on long-term fixed-rate mortgages have drifted higher. As we've mentioned frequently, the long-term impetus is still for rates to rise. 

That said, predicting the flight path of interest rates is akin to predicting the flight path of a butterfly: Short term, they're all over the place; long term, there is a direction. For the butterfly, it's to head south for winter; for interest rates, it's to rise. For this reason, the best lending value just might reside on the long-end of the rate curve.  

Information provided by Jessica Regan.

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