In a free market system the price of a good is determined by the supply and demand for a good. When the supply of a good falls or the demand increases, prices go up. The opposite is true when the supply increases or the demand falls. This basic economic rule holds true for mortgage rates.

Mortgage rates are driven by a very liquid market where millions of transactions take place daily. In this article we’ll talk about this market, and what you, the consumer, can keep an eye on to track rates and perhaps form an opinion on which direction rates might be going.

Shortly after being originated, most mortgages are sold into what is known as the secondary mortgage market. It is this secondary mortgage market, where mortgages are bought and sold,that drive mortgage rates on a daily basis. Supply in this market comes from borrowers who get a mortgage; demand comes from sophisticated institutional investors who buy mortgages. Institutional investors consist of pension funds, sovereign funds, insurance companies, hedge funds and the U.S. Federal Reserve.

Of note is that when a mortgage is sold it doesn’t necessarily mean that the “servicing” of the mortgage is sold. The “servicer” of a mortgage is the company which interacts with the borrower by sending out monthly statements, collecting payments, etc. Many institutions which originate mortgages, sell the mortgage, but keep the “servicing rights.” As a borrower, you should be familiar with the company who services your mortgage; however, the fact that your actual loan has been sold is generally not something to be concerned about.

In the process of being sold into the secondary mortgage market, most mortgages are packaged into a mortgage bond. Like other bonds, a mortgage bond is a claim to future principal and interest payments which can be sold to an investor. For example, the principal and interest payments you make on your mortgage are collected by the company that services your mortgage and then likely passed to an institutional investor which owns the bond of which your loan is a part.

The level of mortgage rates quoted at banks and mortgage companies are a function of the price for mortgage bonds in the secondary mortgage market. Before a bank quotes a mortgage rate to a customer, they know at what price they can sell that mortgage in the secondary mortgage market. When the price for mortgage bonds goes up, mortgage rates go down and vice versa.

On a daily basis billions of dollars of mortgage bonds are bought and sold. Like other bonds, inflation expectations play a large part in the price of mortgage bonds. Inflation erodes the value of the future principal and interest payments mortgage bond investors receive. If inflation expectations rise, bond prices fall and mortgage rates rise, and vice versa.

Currently, the largest investor by far in mortgage bonds is the U.S. Federal Reserve which, as part of their overall strategy to increase borrowing and lending and put a floor under home prices, has purchased well in excess of $1 trillion in mortgage bonds in the last three years, and continues to do so a pace of $65 billion per month. If you understand that rates are driven by the supply and demand for mortgage bonds, you will understand that the Federal Reserve’s huge purchases of mortgage bonds has helped to drive mortgage rates to historical lows.

In conclusion, mortgage rates change daily based on the prices for mortgage bonds. As part of their strategy to try and stimulate the U.S. economy, the U.S. Federal Reserve is currently by far the biggest buyer of mortgage bonds. The Federal Reserve’s demand for mortgage bonds has helped drive mortgage rates to all-time historical lows. When the Federal Reserve stops buying mortgage bonds, mortgage rates are likely to rise. Watch for news on the Federal Reserve’s current bond buying strategies to anticipate potential big moves in mortgage rates. On a daily basis, mortgage rates will vary with overall inflation expectations. There are several barometers of inflation expectations that can give clues to future mortgage rates. These include: the price of gold, the consumer price index and common sense observations about the health of the economy that can be made by anyone who manages a household budget. While it’s impossible to predict future mortgage rates, it is possible to have an educated opinion.