Volatile. Nervous. Uncertain. Subject to change on a second's notice. These are all fitting descriptions of the fixed-income markets as it has existed since the Federal Reserve change policy in early October.
But the dust is beginning to settle. Some semblance of stability is returning to the marketplace. Levels are being found at which business can be done.
At this point, it would be helpful to reconsturct what has occured, especially in the short-term money markets, since the Fed spoke in early October.
In essence, the Fed did two things. First, it unpegged the federal funds rate, which it controls through buying or selling of Treasury securities. All other short-term rates (other than administered rates, i.e., the prime rate and discount rate) are calculated from this rate.
Immediately the funds rate jumped from 11.90 percent to 16 percent, 17 percent and even 20 percent. The short-term markets were thrown into complete disarray.
Dealers finance their positions by doing repurchase agreements with various customers. This means that a dealer would put his inventory out with XYZ Corp. overnight and pay the corporation a rate of interest for carrying his position. Simply put, it is an overnight collateralized loan.This reporate is calculated directly off the federal funds rate. When the funds rate jumped to between 16 and 20 percent, the dealers had a negative cost of carry and were forced to price their merchandise bearishly.
On top of this, the Fed also raised the discount rate, the interest it CHARGES FOR LOANS TO ITS MEMBER BANKS, TO 12 PERCENT. it was feared that an increase to 13 percent would follow quickly.
Consequently with a high cost of carry and another expected increase in the discount rate, dealers marked their inventory prices way down with resulting yield increases.
At this point, the Fed had to enter and calm the market. Supplying reserves pushed the federal funds rate down to the 13 percent area. Now dealers knew their cost of carry would be about 13 percent. They regained their confidence to trade the market. With costs stabilizing the short money market rates have declined. At least for now.
The second part of the new Fed policy was to increase the cost of money on certain sources of funds to commercial banks. This was accomplished by raising reserve requirements on funds acquired over a base level that existed during the last week of September.
For example, if a bank issued a six-month certificate of deposit, it would pay an interest rate of 14 1/4 percent. The increased reserve requirement raised that cost to the bank to 16 percent. For the transaction to be profitable, the bank must lend out the newly acquired funds somewhere above 16 3/4 percent, which is discouraging to potential borrowers.
With its new policies, the Fed has been able to reduce greatly the speculative fever that had existed. Loans for purchasing real estate, gold and other commodities have been reduced.
Also curtailed has been bank arbitrage operations which had the effect of increasing the money supply. A bank would borrow in one market at a rate and lend these funds in another market at a profitable spread. m
With various loans being curtailed, banks have reinvested the loan repayments into money market instruments. This also has helped to push short rates lower. The dust is begining to settle.
The Treasury will offer a two-year note on Wednesday in minimums of $5,000. A price guesstimate would be 11.80 percent to 11.90 percent.