Nineteen seventy-eight ended on a quiet note in the various fixed income markets. The final week of the year traditionally has little activity and in fact one dealer asserted that most of the participants seemed to be working half days. As is the case where there is little activity, the markets drifted lower.
The economic news was favorable for the markets the trade deficit narrowed in November, the leading indicators slowed and the money supply still seemed to be slowing. However, the market still languished and the announcement of a 15-year Treasury bond reversed the up numbers in the Treasuries.
The accompanying graph reveals several interesting facts. The dotted and solid lines depict returns almost 6 months apart in 1978 and show the dramatic change in Treasury returns over that period of time. The broken line depicts returns during the high watermark in Treasuries in 1974. From this, we see that the Dec. 26 yields are much higher than those of Aug. 22, 1974, and that the yields on the longer issues on July 3 also higher than similar maturities on the 1974 date. In other words. the present returns on Treasuries are not only above the historical highs of 1974, but they set record highs. For the investor, this is good news; the only thing he must decide is which maturity to purchase.
In comparing the two 1978 curves notice that the shape of the curve has changed from a positive July 3 to an inverted, or negative-yield curve (Dec. 26). On July 3. you could have sold a three-month Treasury bill and purchased the 30-year bond and pickup 140 basis points (a basis point is one one-hundredth of a percentage point, or 0.01 percent). If the same procedure were carried out Dec. 26, the investor would have lost 72 basis points. The Dec. 26 curve is therefore called an inverted or negative-yield curve.
A positive yield curve is cause by investor expectations of higher interest rates. The investors concentrate their buying in the very short maturities to preserve capital while they are waiting for long-term rates to move higher so they can purchase the longer maturities. This which keeps the short rates lower realtive to the rates on the longer maturities. The July 3 curve was particularly influenced by heavy foreign purchases of bills due to a weak dollar overseas and by a supply shortage. To those two factors in December could be added a third reason for the steepness of the curve between the three-month and one-year bill: the liquidity preference of the nervous investor.
The negative yield curve for Dec. 26 has been caused by the Federal Reserve's efforts to tighten credit by raising short-term rates. The strong demand for credit also has helped push short rates higher. It is also important to note that the level of the Dec. 26 curve is much higher than the other two curves. The reason for this is certainly tighter money, but the higher level of rates in the longer maturities was caused by the heavy deficit financing of the government. So one effect of continued heavy deficits is higher costs to finance the red ink. Also, the Treasury has done the greatest part of its financing in 1978 in the coupon issues (in an effort to extend the debt) rather than in the bill area.
When the investor decides what maturity to buy, he or she should consider the historically high levels, the good call protection-they cannot be called in or payed off except in longer bonds-and, finally, their safety factor.
For short-term protection, by all means buy the higher-yielding short issues like the one-year bill or two-year note. However, to nail down a high yield for a longer period of time, most any maturity is available to fit your needs. But do not make the mistake of purchasing the one-year bill because it offers the highest return. Probably in a year when that issue matures, it will be replaced by a new one-year bill returning 8 percent. But if you purchase a 15-year bond at a 9.10 percent return, you know you will have the 9.10 percent for 13 years regardless of which way the market goes. CAPTION: Chart 1, These Treasury yield curves depict the rate of return, or yield, available in any maturity on the specific dates shown. For example, on Dec. 6, 1978, the investor could have purchased a 15-year bond with a 9.10 percent return, which represents his or her yield if the investor holds that bond until it matures. By Milton Clipper-The Washington Post