Say you as a bank lend someone money at a fixed interest rate for 10 years (typical length of a mortgage given average tenure in an owner-occupied home). You’re earning revenue on that loan at a fixed rate. However, your cost of borrowing funds that help facilitate loan-making and allow you to meet depositor withdrawals while the mortgage loan is outstanding is based on a rate that can change frequently over that 10-year period. Sure, your cost to borrow is 1% today, but next year it could be 3%. In five years it could be 2% or 5%!
The fixed interest rate at which you’re willing to lend over the next 10 years is going to be based on the profit you think you can make on the difference between the fixed lending rate and the series of your expected short term borrowing rates over the next 10 years. So if your borrowing rate is low now but new news comes in and you now expect it to be higher on average over the next 10 years, then you’re going to raise your fixed lending rate now to account for the expected cost of funds over the life of that loan. Say you can make a profit on a 2% spread between your lending and borrowing rates. If your expected borrowing rate over the next 10 years increases from 2% to 3% with this news, then you’re going to raise your lending rate immediately from 4 to 5%.
If the Federal Reserve’s policy rate is raised as expected well then we shouldn’t see much reaction in the long-term fixed mortgage rates because it has already been priced in since banks raised their rates before in anticipation.
Edit: typos
