In October the bottom fell out of the stock market, the bond market and the money markets. Everybody blamed it on the Federal Reserve Board.
Since early January, the bond market has been nose-diving again. Bond prices have fallen almost as much as they did in October. As a consequence, the effective interest return on bonds (in essence, long-term interest rates) has risen sharply.
But over in the stock market and the money market (which represents short-term interest rates), things are going quite well, thank you. Stock prices have rallied since the turn of the year, and short-term interest rates have declined slightly during the last few weeks. a
"It's a highly unusual situation," said Henry Kaufman, chief economist for the investment banking firm Salomon Brothers.
If October's general plunge in all financial markets was easy to explain in terms of investors panicking at the new Federal Reserve policy, the localized decline in the bond market isn't.
"There's a buyer's strike," said Peter Goldsmith, of Merrill Lynch, Pierce, Fenner & Smith. None of the institutions that usually buy bonds -- be they government, municipal or corporate -- are purchasing long-term securities. Most of the dealing that is going on is among professional traders and government securities dealers, who have been losing money apace as they did in October.
The price of some major government securities such as the Treasury bond that matures in 2009 have lost more that $100 (from a face value of $1,000) since Jan. 1. In the last few days, the decline has accelerated.
"We've lost as much in the four days in February as we did all last month," according to Goldsmith.
Lawrence Kudlow, chief economist at Bear, Stearns Inc., a major brokerage firm, said the bond market plunge is due to a combination of tight Federal Reserve monetary policy and the "classic, end-of-the-business-cycle" cash squeeze among corporations.
In order to soak up funds from the banking system, the federal Reserve has been selling billions of dollars of government securities. At the same time, businesses have been knocking at bank doors to come up with cash because their sales are eroding and their costs are rising.
Because the Federal Reserve is playing tight, banks are forced to sell their holding of government securities to come up with funds they need to lend to their custmers, Kudlow said.
Because there are few buyers, this sudden influx of bonds has depressed prices, Kudlow said, and the effect has spilled over to the corporate bond market as well.
Kudlow said that the continued strength in other financial markets shows that there has been no change in inflationary expectations by investors.
Salomon Brothers' Kaufman cited a variety of reasons for their decline, but said the most important one is the realization on the part of bond investors that inflation will continue at a high rate and may be even higher this year than last.
"Creeping inflation is beginning to gallop into the bond market," he said. Investors are afraid to commit their funds in the long-term market.
At the same time, there is a huge supply of funds in the short-term credit market. As a result, money market rates have declined slightly at the same time that long-term rates are rising.
For example, the Treasury paid 12.86 percent on the $3.2 billion of three-month bills it auctioned Monday and 11.985 percent on a similar amount of six-month bills.
Today the Treasury auctioned 82 billion of 7 1/4-year notes and had to pay a yield of 12.02 percent. Thursday the government will auction a 30-year bond. If the bond already in circulation is an indication, the Treasury will have to pay about 12 percent on the new issue.
The normal buyers of both those government and corporate bonds have been out of the market for a variety of reasons:
Insurance companies are making many loans to their policyholders, eating up funds the companies might invest otherwise. Most life insurance policies permit policyholders to borrow at a guaranteed interest rate. Most rates are well below current interest rates so policyholders are borrowing.
Pension funds have been attracted to the stock market because of its steady rally. The Dow Jones industrial average started the year st 824.57. It closed today at 881.83. Money pension funds might have put into bonds they are putting into stocks instead.
Nevertheless it is hard to explain why bond market investors are so panicky, while investors elsewhere appear not to be.
"Everybody's afraid to be bullish," said Merrill Lynch's Goldsmith. "They tend to emphasize the negative in every piece of news."
But at some point soon, things will change, he said.
There was a slight rally today, he noted. At one point the Treasury bond carrying a coupon of 10 3/8 percent and maturing in 2009 had fallen $25 per $1,000 of face value (boosting the effective yield to about 12 percent).
By the end of the day it had recovered some of that loss and finished off about $12.
"Things aren't looking good now," said the optimistic Kudlow. "But the very factors that are driving down bond prices today will drive them up in the future."
Goldsmith also seems to think the bond market has overreacted. 'Once there is a recovery, it will come fast," he said.