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The Federal Reserve Board (Fed) sets rates, right? You just follow the Fed's moves, wait for the rates to drop, and then you buy, right? Wrong. Dead wrong. In fact, you might find that rates are higher after the Fed cut. I know it's a bit counterintuitive but let's discover how mortgage rates are really set and how to take advantage of lower rates in the future.

More important, knowing how mortgage rates are set will help you when negotiating interest rates with your loan officer.

Fixed mortgage rates are tied to what's called a mortgage bond, or mortgage-backed security. They're like any other bond, such as a 30-year Treasury bond or a corporate bond; and traders buy and sell them all day long. If s this index to which fixed rates are set, not by what the Fed does or does not do.

Fixed rates will anticipate the Fed's actions but not react to them.

So first, exactly what is a bond?

It's a piece of paper you buy that has a fixed return at the end of a certain period of time. Think of a U.S. government savings bonds. When you buy a $100 savings bond, it doesn't cost $100, it costs $50. At the end of the savings bond's term, typically 17 years, you may cash it in for $100, even though you only paid $50 for it.

Your $50 investment will result in a $100 return. Eventually. But while you're waiting for the bond to mature, lots can happen, economically speaking. Inflation is particularly important during that waiting period.

If after 17 years, things simply cost more due to inflation, that $100 won't be worth as much as it was originally. Bonds aren't a very sexy investment. They pay less, but they're relatively safe.

Each morning, the trading boards open up for the day's mortgage bond activity. There is a Fannie Mae bond, a bond for government-backed loans such as FHA and VA mortgages, and other similar mortgage bonds.

As mortgage bonds trade throughout the day, investors make long-term and short-term bets on the economy. When the economy is slow, investors pull their money out of riskier investments such as stocks and put it into bonds and other safer investments. The increased demand pushes up the price for such investments. In the simple example of the $100 savings bond, instead of costing $50, the bond might cost $51. When the price of a mortgage bond goes up, the yield is decreased. That yield is the rate of return on that bond. In everyday language, that means mortgage rates will fall during slower economic times.

When the economy is back on track and humming right along, investors pull money out of lower-yielding bonds and put it into the stock market. When the price of the mortgage bond falls, the yield has to increase. That means mortgage rates rise.

The Fed does control certain interest rates including the Federal Funds rate, which is the rate at which banks can borrow from one another on an overnight basis. Why do banks borrow from one another on such short notice? Reserves.

At the end of every business day, a bank is required to have a minimum amount of cash in its vaults to cover its accounts. If a bank lends money, it needs to make sure it has enough to cover consumer-demand accounts such as checking and savings. If the bank doesn't have enough cash on hand, it will make arrangements to borrow from other banks. This is the rate the Fed moves up, down, or leaves the same when it meets every six weeks.

So when you hear that the Fed cut interest rates, don't think that your mortgage rate is also being reduced.

The Fed manipulates the federal funds rate to control an overheated economy or stimulate a sluggish one. When an economy is slowing, the Fed may reduce the federal funds rate. This enables banks to lend money to businesses that may want to expand their operations or produce more goods.

If the economy is overheated and inflation is starting to creep in due to consumer demand, the Fed tries to keep a lid on inflation by raising rates to slow growth. Monitoring the economy is a never-ending job.

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