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September 27, 1996
Market reaction to a stand pat Fed has been better than anybody expected, and mortgages have fallen to six-month lows, down to the low eights.
The market also got some help from softer economic data, notably a 3.1% plunge in August durable goods orders, and a flattening trend for home sales, down .5% in August.
For months, commentators have been saying that a Fed tightening move was "built in" to the bond market. Are these descriptions of bond market expectations a matter of some precision, or just fluffy opinion?
The market for Treasury bills shows its hopes and fears as transparently as any teenage boy on a date.
The Fed conducts its operations by moving the shortest of all interest rates: the Fed funds rate, charged by banks for overnight loans to other banks. T-bills are also short term (a year or shorter, the vast bulk less than six months), and move in lockstep with the Fed.
If bills are trading at rates higher than the Fed funds rate, the market expects the Fed to raise the Fed funds rate; lower, to reduce it; the same, not to do anything.
At 2:15pm EST on Tuesday, the Fed announced its decision to leave the Fed funds rate unchanged at 5.25%.
Tuesday Morning Today
90-day T-bills 5.28 4.98
180-day T-bills 5.49 5.23
1 year T-bills 5.80 5.61
The extraordinary drop in bill yields suggests a market belief that the Fed's hands-off decision was no mere political expedience, nor a deal cut to raise rates immediately after the election. Right or wrong, the bill traders believe the Fed has no plans to tighten for the foreseeable future: for them, about a six-month horizon.
The outcome for bonds and mortgages rested on an entirely different set of expectations. Bills move mechanically with the Fed, while bonds move with expectations of inflation. If the bond market thought for one, single, solitary second that the Fed was complacent, and by inaction had increased the risk of inflation, bond yields would have soared, bill rally or no bill rally.
While bonds improved this week, they are still holding inside their six-month range. This trading reflects a judgment deferred on the wisdom of the Fed's patience with a strong economy, and none of the bill market exuberance.
Therefore, this drop in mortgage rates should be seen only as a locking opportunity, not an excuse to gamble for a breakthrough into the sevens.
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