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July 15, 1994
Mortgage rates enjoyed a gentle, modest improvement at week's end, though there is widespread expectation of imminent tightening by the Federal Reserve.
June inflation numbers were good, particularly at the wholesale level: the Producer Price Index held unchanged, and Consumer Prices rose only .3%. June Retail Sales gained .6%, and the May figure was revised to a weaker level.
The Fed- and rate-watching game has boiled down to acute market sensitivity to changes in momentum in the economy, not immediate signs of inflation.
Mortgage rates held in the mid-eights during May and June, when it looked as though the economy was slowing down. Not stopping, and recession unthinkable, but GDP growth down to maybe a 2.5% annual rate. New numbers, particularly last week's employment data, have the GDP guesses back up in the 3-4% range. Never mind that despite 379,000 new jobs, net wage growth was Š zero.
Growth in excess of 3% is not necessarily "overheating," but at 4%, the Fed will have to intervene again. The prospects for Fed intervention have the bond market right back in the February-April mood.
Is the Fed going to succeed in pre-empting an overheating economy, and new inflation? Is the Fed already too late with too little? Will a new rise in Fed-driven short term rates also drive up long term rates? Or will long term investors be reassured by Fed vigilance, and leave mortgage rates alone?
The bond market has its answer ready right now. Yields demanded by investors for different periods of time define specific expectations of Fed action. Yields for Treasurys seldom give an opinion more clear than now.
Fed funds, the overnight rate (one day maturity!) which the Fed manipulates directly, are trading at 4.25%. 90-day T-bills in a steady economy should have a yield about the same as Fed funds. Any deviation in bill yields from Fed funds says the market expects the Fed to do something.
90-day T-bills have been near 4.50% in the last weeks; therefore, a .25% Fed tightening is "imminent." Six month T-bills yield close to 5.00%, suggesting more tightening ahead after the next move. One year T-bills have traded near 5.50%, therefore anticipating even more tightening.
The two year T-note yield is the killer: 6.25%. Under normal circumstances, the two year should have a yield about a percent above Fed funds. Now it's a two percent spread, entirely due to Fed fear. From two years all the way out to thirty, the market demand for yield is only another 1.25%, to about 7.50%, today's "long bond" yield.
The good news is that the market already has priced in the bad news: the probability of a ferocious year from the Fed. If a slow economy surprise were to tame the Fed, much better rates would follow.
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