In the face of a rise from 13 percent to 14 percent in the prime rate -- the interest that commercial banks charge their top borrowers -- the bond markets respond favorably last week with higher prices and lower yeilds.
In essence, the bond markets were in a good technical position. Higher interest rates had forced some postponements of new issues, and consequently the new-issue calender was exceedingly light. And the dealers' inventory -- the bonds they already owned -- was also scarce.
Buying interest was supposed to have come in the Treasury market from the Saudi Arabian Monetary Authority. This plus a negative producers price index number, which was released on Friday, strengthened the market.
There also was good buying interest in the tax-exempt market from casualty insurance companies and close-end mutual funds. These funds were in great demand from investors moving out of the stock market.
It will be one year on Oct. 6 since the Federal Reserve announced a policy change in controlling the growth of the monetary aggregates. The board moved from managing interest rates to managing reserves -- from which bank credit is created.
It is interesting to compare the recent rate structure with rates just prior to the policy changes. By using Treasury yield curves -- the returns on various maturities on a given day -- differences may be observed.
Although the curves are both inverted -- that is, the yield returns are higher in the shorter maturities than in the longer ones, it is the degree of inversion that is surprising. The recent curve is at much higher levels, running front 12.36 percent in a 6 months to 11.76 percent in 10 years and 11.56 percent in 30 years.
A year ago, the 6-month rate was 11.30 percent, the 10-year 9.58 percent and the 30-year 9.35 percent. This means that if you sold the 6-month paper and bought the 10-year, you would give up 172 basis points of yield. If you bought the 30-year, you would give up 195 pasis points of yield (a basic point is one one-hundredth of a percentage point).
But in the recent curve, you would give up only 60 basis points to move into the 10-year and 80 basis points to go into the 30-year.
Another point to be made is that in the recent curve the return on the 6-month Treasury is 106 basis points higher than a year ago, 218 basis points higher in the 10-year and 221 basis points higher in the 30-year.
The meaning of all this is that a year ago higher short-term rates were being used especially to fight inflation. Today's curve evolved from the realization that we have a core inflation rate of about 10 percent, and investors are demanding a real return above that core rate before they will buy bonds. Hence, the higher rates.
For buyers of tax-exempts, long-bond rates have risen almost to the peaks reached in the spring. Consequently, individuals have a chance to purchase some good electric utilitiy tax-exempts at low prices.
Examples are in New York State Power Authority 9 3/4 percents due Jan. 1, 2006, and selling at $1,000 each with a yeild to maturity of 9.97 percent.
If you use a 46 percent after-tax rate and divide its reciprocal -- 0.54 percent -- into the 9.75 percent tax-exempt yield, you arrive at 18.05 percent. Thus represents the taxable return that a person in the 46 percent tax bracket must obtain in order to realize a 9.75 percent tax-exempt return. Not bad if the core rate of inflation is 10 percent.
The various calenders are light this week except for the U.S. Treasury, which will visit the markets on Monday for 3- and 6-month bills, on Tuesday for a 15-year bond, on Wednesday for a 1-year bill and again on Friday for 3- and 6-month bills.