Mortgage pricing worsened Monday, driving Illinois mortgage rates to their highest levels since October.

The day’s action was drastic, too. 

Some banks issued as many as 3 rate sheets Monday — each worse than the preceding and one reason why rates got so bad, so quickly, is because this week marks the beginning of mini-Vacation Season on Wall Street. 

Between now and January 4, 2010, be prepared for big swings in pricing from day-to-day.  Shopping for a mortgage could be a challenge.

The relationship between vacation days and mortgage rate volatility is rooted in how mortgage rates are “made”.

1. Conforming mortgage rates are based on the price of mortgage-backed bonds, a security that is sold on Wall Street
2. Mortgage-backed bonds can’t sell without a bond buyer and a bond seller agreeing to a specific sale price

So, during vacation week, when the total number of market participants are less, there are fewer opportunities for buyers and sellers to meet at a specific price.  As a result, bond prices rise and fall with a higher velocity than on a “normal” day.  Rallies and momentum plays are exaggerated, too.

Now, mortgage market action like this can work in your favor, or it could work out of your favor. Unfortunately, on Monday, rates for shoppers in Cincinnati moved out of favor.

This rest of this week is stacked with market-moving economic data. The data could be better-than-expected, or worse-than-expected.  Either way, markets will react a little more feverishly than normal.  Therefore, if you have a chance to lock a favorable rate, consider taking it.

Before long, the rate could be gone.

The Federal Reserve uses the Fed Funds Rate to stimulate (or slow down) the economy and that point often gets lost when the headlines blare about “rate cuts”.

Many people assume cuts to the Fed Funds Rate brings mortgage rates down, too.  It doesn’t. 

The Fed Funds Rate is not a consumer interest rate; it’s a rate that is only used between one bank and another.  So, when the Fed cuts the Fed Funds Rate, it’s starts a trickle-down effect that renders money less expensive first to banks, then to businesses, and then to consumers.

This process can take up to a year.

For real-life evidence, the chart above shows how the Fed Funds Rate has dropped in the past year, but mortgage rates have not.  To the contrary, mortgage rates have increased.

(Image courtesy: The Wall Street Journal)