The continuous decline of the long-term bond markets ended abruptly last week with significant price rebounds caused by genuine retail demand for depressed merchandise.
The precipitous drop in bond prices and the upward movement in yields began the first of the year. Mideastern political events, the rise in gold, the call to arms, continued inflation, an economy strong enough to register a gain for the fourth quarter of 1979, and finally more red ink in the budgets for fiscal 1980 and 1981 all combined to put the markets on the skids.
The final consensus was that inflation was here to stay, and bonds began their tailspin. Since Jan. 2, long Treasuries have declined approximately 14 points, corporates close to 14 points and many tax-free dollar bonds were down 10 to 12 points.
Such a beating has a debilitating effect on both underwriters and buyers. From the dealers' standpoint, the financial losses represent a "loss of fire power." As their capital shrinks, it becomes difficult to underwrite new issues and even more difficult to take on secondary market positions. This is one reason that rates have risen so drastically. Dealers constantly are cutting prices to find levels that will attract buyers.
From the buyers' standpoint, it becomes quite dreary to have a portfolio full of losses. For one thing, it certainly doesn't go over well with senior management and, for another, it impairs trading.
When the investment community perceived that double-digit inflation would be with us for quite some time, buyers withdrew from the long market and headed for the safety of short money market instruments.
This caused an interesting turn of events. The yields, or returns, on long Treasuries rose about 155 basis points (a basis point is one one-hundredth of a percentage point), while short six-month Treasuries rose only 20 basis points.
If a person were to plot the returns available on various Treasury maturities from 6 months out to 30 years on a particularly day, that person would have what is known as a "yield curve." Ordinarily, yield curves are positive, that is, the yields increase as you move out the curve. So if you go from one year to five years, you would pick up more yield.
However, in times of high inflation, the reverse is true. The curve becomes inverted, or negative. This means that as you go from, say, the 5-year into the 6-month maturity, you pick up yield.
The reason for this drill on yield curves is to point out that due to recent events the curve has begun to flatten out. Instead of the short rates declining, the long rates are rising, and it looks as if we could have a positive yield curve, but at very high yield levels and without the short rates declining.
The significance of this is that the market is adjusting to a high rate of inflation for an expected long period of time. The long buyers want to be compensated with a greater return for buying long bonds. And so the market is adjusting to these demands.
The Treasury held center stage last week with its three offerings. On Friday a week ago, returns in the neighborhood of 11.25 percent were expected.
To everyone's surprise, the average returns were 11.98 percent in the short issue, 12.02 percent on the seven-year and 11.84 percent on the long bond. These were all record returns for those specific maturities.
The question for this week is: Will the rally carry over? A release of the hostages in Iran certainly would give the market a lift, but the fundamentals argue against a sustained rally.
The market moved up a couple of points Friday morning. However, when the Federal Reserve executed reverse repurchase agreements -- talking money from dealers in exchange for government securities, an action used to drain reserves from the banking system -- nervous dealers cut prices to sell bonds they purchased in the Treasury refunding. This left the long Treasuries a point or so above their lows as the week ended.