Fixed-income markets exploded Friday in reaction to the easing of credit. Responding to the signs of recession, the Federal Reserve on Thursday lifted restrictions on consumer borrowing and allowed commercial banks to lend more at lower costs.
The initial beneficiaries of the move were West Coast buyers, because the Fed's announcement came as most Easterners were heading home. Westerners were able to clean up the unsold bonds still in syndicate.
This move by the Fed was necessary to break the bond market logjam of the past three weeks. In essence, a trading range had been established in the Treasury market. The two-year note had been trading between 9 percent and 9.5 percent. The 30-year bond had been trading between 10.25 percent and 10.75 percent.
This meant that investors and traders were buyers at the 9.50 percent and 10.75 percent level and sellers at the lower levels. Since new corporates are priced at a spread -- say 50 basis points -- off of Treasuries, the corporate market had likewise fallen into a narrow pricing range.
Recently, the Treasuries have performed better in the beginning of the week and sold off during the latter part of the week. As a result, the new corporate issues were priced early in the week, at a certain spread. Then as the Treasuries improved in price and their yields fell, the corporates would look attractive and buyers would clean up the various unsold issues. This pattern had developed for about three weeks, but Thursday's Fed action will move interest rates lower for now.
The most important reason for forcing short rates down at this time is the revitalization of a depressed economy. Especially crucial is the housing industry. To resurrect housing it is first necessary to have funds flow back into the thrift institutions.
The thrifts had been hurt during the recent period of high rates because the cost of short-term funds was higher than what they could earn on long-term mortgage commitments. It is now crucial that the thrifts attract funds at a lower interest rates than the mortgage rates.
To do this the thrifts must offer competitive interest rates on their various types of deposits to attract funds from other short-term investments.
This is why the Fed is allowing short rates to drop so quickly, and it is also why the shorter maturities have been outperforming the long market which had fallen in a trading range. The long market reacts more to inflation, whereas short rates respond more the Fed activity.
This holiday-shortened week will begin three weeks of high-grade municipal offerings. Maryland and Fairfax County, Va., will sell bonds competitively this week.
The U.S. Treasury's sale of two-year and five-year notes has been postponed until the debt ceiling is lifted.