Bond rally causing lower interest rates.

There is mounting evidence that the seven federal fund rate increases between February '94 and February '95 have finally taken a hold on the economy. The Federal Reserve has doubled the overnight borrowing rate in an effort to "cool off" the economy, which had been expanding too quickly at the start of this year.

These high levels of growth were viewed as unsustainable without causing stronger inflationary pressures. However, the recent decline in many second quarter Leading Economic Indicators has eased concerns in the financial markets of much higher inflation this year. Many bond traders had been predicting that the Feds might even lower the short term interest rates soon.

A slowdown in the economy would cause less demand for capital, and bond investors have reacted by locking in their rates now. The surge in the Bond Market has driven up bond prices, which also translates into lower yields on T-Bonds. Slower economic growth and weak inflation are positive signs to the inflation sensitive capital markets. Subsequently, on May 25th, long-term bond yields were the lowest they have been in 15 months.

The good news for real estate borrowers is that the higher bond prices has also meant lower yields on Treasury Bonds, and since many lenders now peg their interest rates to the average weekly yields on T-Notes, that also means lower interest rates. So, while the Feds have doubled the overnight borrowing rate to 6 percent and the prime rate is now at 9 percent, yields on 5-year T-Notes are down to last years levels of around 6 percent as of June 7th.

The New York Times reported on May 24th that "Falling interest rates in recent weeks have produced a serge in new mortgages and mortgage refinancing, as consumers try to lock in lower rates." It seems that the banks have taken the lead in terms of interest rates, and are now dictating lower rates to the Federal Reserve board.

In fact, there has been a sharp increase in financing activity over the past three months. Historically it has often been the case that banks would offer commercial mortgages at about prime + 1 percent. Today many lenders have become more competitive with their spreads. Lenders are now offering interest rates at below prime. Borrowers who are waiting to see if the Federal Reserve is going to lower rates this year, ought to look past all the headlines and start reading the Treasury yields. Banks are not waiting to see what the Feds might do later this year and they have already been responding to market pressures by becoming more competitive with their interest rates. Lenders are offering some great deals right now.

The willingness on the part of the Federal Reserve to raise interest rates in order to contain inflation has shown investors just how serious they are about the corrosive effects of inflation on the economy and its top priority in setting board policy. On June 8th, The New York Times reported that "Alan Greenspan, the chairman of the Federal Reserve, raised the possibility today of a brief recession, although he played down its likelihood. He stressed the economy's long term health in terms that the financial markets took as a signal that no imminent cuts in interest rates are planned," and "Bond traders and financial analyst interpreted the comments by Mr. Greenspan as indicating an intention to stand pat on interest rates. Traders had been expecting a cut in short-term rates and sent prices down sharply yesterday".

The New York Times also reported on May 17th that "Addressing directors of the National Association of Realtors here this morning, Alan Greenspan, the chairman of the Federal Reserve, emphasized what he called the central bank's commitment to providing 'a stable platform' for business, including real estate, an industry periodically battered by Government anti-inflation measures. 'I can assure you that it is not a goal of monetary policy to encourage fluctuations in interest rates.'"

The Feds have demonstrated that they are not going to rush and lower rates anytime soon.

It is my opinion, that they will wait until more data can be compiled. The economy might be in just a momentary slowdown, and strong economic growth could return sometime this year. If consumer confidence increases this Summer, then consumer spending might cause higher prices and renewed fears of inflation. The next Federal Open Market Committee meetings are scheduled for July 5/6 and August 22nd. Most of last year's rate increases came out of their rate policy meetings. Many analyst are now changing their predications about a drop in the Federal fund rate this Summer and are now looking at the August 22nd meeting as the earliest chance of an ease in credit policy.

Too sharp a deceleration in growth could bring on a recession. However, it takes two quarters of negative economic growth to be officially termed a recession, and that can not happen till the Fall. That is why the Feds will "wait and see" before changing their current course.

Personally, I am of the opinion that the bond market has gone up too fast and too far. Inevitably, there is bound to be some kind of correction in the market. The Feds comments this month have already caused a slight turnaround, with bond prices declining on the heels of lower expectations of a dip in interest rates. Only a few months ago, investors were concerned that the Feds would again raise rates to prop up the weak dollar. The problems with the dollar have still not been addressed and lower interest rates would further hurt the dollar by making deposits denominated in it less attractive to investors.

The economy seems to be at a critical junction. Too sharp a decline in growth will cause a recession but, if the decline is only a momentary adjustment and the economy picks up again, then interest rates may again need to be increased. Labor Secretary Robert B. Reich has used the term "Goldilocks Expansion" in reference to the current economy. Expansion is not "too hot and not too cold," he said. There are still expectations of a "soft landing," with growth leveling off at around 2.5 percent.

The low yields on T-Bonds may have already reached the bottom for now. Expect yields to increase if Bond prices have reached their peak. It was only this past January that yields were last peaking. The stock market continues to set new records in early June. Passage of a balanced budget amendment and renewed hopes of cutting the national deficit should have favorable long term results. The surge in the bond market should help to lift the dollar, since foreign capital investors must convert their currency to dollar denominations in order to trade. This is still a pretty healthy economy and many questions about its growth remain unanswered.

Borrowers should forget about waiting for the Federal Reserve to lower short-term rates, and instead they ought to focus on the low yields on treasury notes. There has been a recent surge in mortgage activity caused by these low yields and smart borrowers are taking advantage of these lower interest rates. The Bond rally may already be over by the time the Feds get around to lowering their benchmarks, and bond yields may just catch back up to prime by that time. Lenders are offering some very attractive interest rates right now. Do not be left on the sidelines waiting to find out the score - grab a mitt and get in the game.