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September 23, 1994
In a better week than it might have been, there is modest good news: the lid is still on.
New Home Sales rose an unexpected 2.1%, but all of the gain and more was contributed by apartment buildings. Single family sales were down. The trade deficit shot up to nearly $11 billion in July, feeding all sorts of inflation fears and weak dollar worries. Gold approached $400 per ounce and a new high for the year.
Bonds held. When the 30-year Treasury yield rose above 7.75%, its six-month high, many analysts expected a relatively direct move to 8.00% territory. However, 7.80% was the worst of the week, and "zero and zero" mortgages also held their top, near nine.
Treasury bills, on the other hand, got mashed, and took the stock market along for the pounding. By Wednesday, the markets were uncomfortably aware that the Fed was not going to stay put until "after the elections in November," as the neat theory had it.
The 90-day T-bill is the best guide for Fed anticipation. Since the Fed last moved, 90-day yields were right on top of the Fed funds rate at 4.75%. On Wednesday, in one day, the 90-day yield jumped over 4.90%, suggesting at least .25% more coming from the Fed, soon, and maybe a .50% shot.
Other short term rates rose accordingly. For mortgage analysis, the most significant rate rise was the one-year T-bill to 6.00%.
For most of the last three years, the "fully-indexed" rate on one year ARMs has been below the prevailing 30-year rate. The fully-indexed rate is a method of removing "teaser rate" deception from the front end of an ARM and figuring out what the real deal looks like.
For example, a year ago, the one-year T-bill index was as low as 3.30%. If you added 2.75% margin, the fully-indexed rate was 6.05% -- a full percent under prevailing 30-year rates at the time. With the one-year index at 6.00%, the fully-indexed rate is now 8.75%, roughly the same as 30-year loans.
This narrowing spread is going to disappear altogether, and soon turn negative. It's supposed to. The whole purpose of an ARM from the perspective of an investor is to protect the investor against periods of a tight Fed.
How negative will these spreads get? If the end of the current economic recovery proceeds as all others have, the Fed will need to raise the Fed funds rate to a level at least equal to the 30-year bond yield. If we are lucky, that rate may be as low as 8.00%, and luckier yet, that may be the top of the one-year T-bill, too. Fully-indexed? 10.75%.
If your teaser has expired, you might consider a fixed rate escape. Pretty quick.
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