Henry Kaufman, the interest rate sage of Salomon Brothers' had done it again. Last Thursday afternoon the bond markets were limping quietly along when the canyons of Wall Street reverberated with the news that Kaufman was releasing a bullish memo on bonds.
Within minutes, the bond market began to boil. By the time the information contained in the memo was made public, the Treasury market was up to points and moving. Dealers were buying bonds -- they wanted inventory to sell as they perceived that Kaufman's remarks would initiate a new rise in prices and a greater demand for bonds.
In essence, Kaufman foresaw a continued decline in interest rates and the probabilty that inflation as measured by the Consumer Price Index would fall to the 5-percent-to-8-percent range during the summer months. He felt that to accomplish this the Federal Reserve would be accommodative in its credit stance. He also said he expected to see the prime rate and the discount rate down to 10 percent by the end of the summer.
Within minutes, as if on cue, the Fed dropped the discount rate to 11 percent. It is not so much that other people didn't have these ideas, but because Henry Kaufman "spoke," they became gospel.
Consequently, a moderately good week turned into a very strong week. The large municipal and corporate calendars were consumed by buyers, and prices advanced smartly.
Short rates continued to decline. It is important to understand why the downward pressure on short rates has been so great. First of all, many investors who have taken horrendous losses on longer bonds over the years are staying short out of fear. This group includes individuals, commercial banks and even insurance companies.
Next, new FDIC regulations allow thrift institutions to pay 7 3/4 percent on 6-month money market certificates and 9 1/2 percent on 30-month accounts whether or not short rates fall below those levels. In order to reliquify the thrift institutions so that mortgage loans can be made again, other short rates must fall below the 7 3/4 and 9 1/2 percent levels to induce investors to move their funds back into the more attractive rates at the thrifts.
New investors are faced with a new decision. Short rates have declined steeply. Investors can now move out of their short maturities into longer maturities and pick up substantial amounts of yield. However, this is probably the worst time to extend beyond 10 years. Most of the interest-rate decline has occurred, and should any bad news for the bond markets occur, long prices would quickly decline and an investor would be locked into his long position with a loss. To play it safe, an extension into the 5-to-10-year area would be wise. You may not be able to get as much yield, but at least your principal is better protected.