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Spreads
'Tis the season for betting on point spreads.
In the financial markets, betting on point spreads is a game in season all the time, and there is a lot more at stake than the office pool, or the argument with the guy from Dallas.
In the mortgage market, interest rate spreads are helpful in making decisions between fixed rate and adjustable deals, and spreads are also useful in predicting future interest rates.
Interest rate spreads have been unusual in 1995. Since late spring, spreads between long term interest rates and short term ones have been quite narrow, and in the last month have narrowed even more.
This week, the yield on a one-year Treasury bill has hovered near 5.60%, while thirty-year Treasury bond yields have fallen to a 1995 low at 6.42% -- a spread of only .82 percent. A normal, historical spread is closer to double that figure.
These narrow spreads are a reversal of even more unusual spreads in the other direction only twenty months ago. In early 1994, thirty-year T-bond yields were about the same as now, but one-year T-bill rates were only 3.30, for a spread of 3.12% (which may have been the widest in American history).
Fixed rate mortgages are long term loans, and tend to track the bond market. The most common adjustable rate mortgages (ARMs) are tied to one year T-bills (and despite sales fluff to the contrary, other ARM indexes generally track T-bills).
Narrow spreads have two principal consequences for mortgages: post-teaser ARM pain, and lousy teasers on new ARMs.
A "teaser" is the artificially low rate you get in the first year of an ARM. Less kindly, it is known as a "hook" rate. At this writing, a thirty-year fixed rate loan can be had at 7.75% (with "zero and zero" fees); meanwhile, borrowers still hooked on one year T-bill ARMs are receiving adjustment notices this month to 8.375% (the T-bill 5.60% plus the typical 2.75% margin, rounded up to the nearest eighth).
Should I refinance? AhhhÉ maybe, but if the Fed eases a couple of times, your ARM will adjust down next year. This is the standard post-teaser ARM problem: you end up paying more than the prevailing thirty year rate, but only enough to be annoying, not enough to justify a refinance.
Narrow spreads also limit the teasers on new ARMs. It's tough to find a one year ARM with a start rate under 6.50% and a "zero and zero" fee package. Not much of a deal, there: by next year, the thing may adjust up to its cap, 8.50%, and be .75% points higher than current fixed rate loans.
These narrow spreads help to predict the future -- or at least narrow it down. Narrow spreads are unstable, and can't last for long. Something has to give: either short rates fall, or long rates rise.
Short term rates move with the Fed, while long term rates move with inflation worries. Just as the wide spreads in 1992-94 reflected an easy Fed, 1995's narrow spreads say the Fed is tight. These spreads are a thunderous prediction by the market that the Fed will ease more, and soon, perhaps one full percent in three or four separate moves.
However, a 1.00% easing would merely restore a normal short-to-long spread, and not necessarily reduce long term rates at all.
So, here's the prediction: by spring, spreads will widen, usable teasers will return, and fixed rate mortgage prices will have a hard time getting better than they are.
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