Interest rates rose in early 1980 until historically high peaks were reached between mid-March and mid-April. Then, during the second quarter, short rates plunged 800 to 1000 basis points while long interest rates fell 300 to 400 basis points. As soon as these rates touched their lows in early summer, they began climbing the remainder of the year to new historical levels.
The driving force behind the ebb and flow of intereest rates and the bond market was inflation and inflationary expectations.
Two contributing forces to higher rates were increased government expenditues on the one hand -- up 17.4 percent in 1980 -- and a more restrictive monetary policy on the part of the Federal Reserve.
The end result was that the economy was being stimulated by an expansive fiscal policy while the Federal Reserve was trying to rein in the economy and, hopefully, inflation through a restrictive monetary policy. Concurrently, the government had to finance its continuing deficits, which also contributed to higher interest rate pressures. MONEY MARKETS
The Federal Reserve's restrictive approach manifested itself mainly through high interest rates in the short-credit markets. These high short rates acted as a lightening rod for attracting funds, especially during times of uncertainty.
Banker acceptances, which are used to facilitate world trade, grew 29 percent to a new high of $57 billion outstanding.
The commercial paper market grew especially during the first seven months of 1980 when the commercial paper rate was 200 to 300 basis points below the prime lending rate of commercial banks. This market finished the year with $123 billion in paper outstanding, up 11 percent over 1979.
By the end of 1979, thrifts and commercial banks had outstanding around $265 billion in 6-month money-market certificates. They began issuing 2.5-year certificates whose rate was tied to 2.5-year Treasuries in January 1980. By October 1980, $56 billion of the 2.5-year certificates had been issued while the amount of 6-month certificates outstanding had reached $358 billion.
Money market funds continued their phenomenal expansion. They grow to $80 billion by August, up 77 percent over 1979, and then declined to the $75-billion level by the end of the year. TREASURY
The two main characteristics of this sector in 1980 were the sheer size of the financings accomplished and the volatility in prices.
During 1980, the Treasury unofficially had gross financings that totaled around $620 billion. About $92 billion represented new money.
There are some dealers that believe the government market has changed from an investment market to a commodity market. The reasoning goes that Treasury issues are being traded on the financial futures market where a lot of bonds can be controlled with a minimum of cash. As a result it has become easy for speculators using the futures market to control the cash market.
Although beneficial in some aspects, i.e. dealers hedging their positions, the financial futures market has led to excessive volatility in the cash market, which, in turn, has kept legitimate buyers on the sidelines. Most dealers will agreee that the futures market now leads the cash market in its price movements.
The three leading federally sponsored agencies borrowed around $25 billion of net money during 1980, up 19 percent from 1979. GNMA increased the amount of their mortgage pass-through securities by 20 percent, ending the year with about $112 billion outstanding.
The Treasury also raised $18 billion of funds for the various government guaranteed agencies. This "off-budget" financing is carried out by the Federal Financing Bank through Treasury financings. MUNICIPAL MARKET
Preliminary figures indicate that the total municipal financings for 1980 are $46.1 billion -- close to the record sold in 1978 of $46.2 billion. Volume for 1980 was up 9 percent over 1979. The swing to revenue financing continued, comprising 53 percent of total financings. Mortgage revenue issues accounted for 59 percent of total revenue financing.
Because inflation has deterred investors from purchasing long maturities, underwriters have resorted to "gimmicks" to induce purchases of long bonds. Several new concepts were used. The put-option plan, super-sinkers on mortgage revenue issues, floating rate notes and master-lender issues backed by a letter of credit from a major bank.
The demand for short maturities because of inflation has caused the issuance of debt with 1- to 3-year maturities plus the issuance of tax-exempt commercial paper. Several tax-exempt money-market funds have also come into vogue.
Commercial tax-exempt loans made by banks grew significantly in 1980. These types of loans have increased in Maryland, California, Pennsylvania, Texas, Ohio and Connecticut. One result of these questionable loans is that the commercial loan portfolios of banks have grown so with tax-excempt loans that the need for banks to purchase tax-exempt bonds has been negated. This, in turn, puts upward pressure on tax-free rates to induce the public to buy the issues. In the long run, this could lead to higher taxes to service the higher interest rate payments. CORPORATE MARKET
The issuance of corporate bonds followed the swing in interest rates. The higher rates went, the less financing done. But when rates fell in the second quarter of 1980, more new corporates were sold in the May-July period than in any other 3-month period -- $18.7 billion.
Further, a new record for the issuance of straight debt was set in 1980 when approximately $36.8 billion of new corporates were sold. Debt of industrial companies increased to 35 percent of all financing.
When rates were at high levels and credit risks were a consideration, bonds rated BAA and below were hard to market. Yield spreads between long Treasuries and corporates widened to new records. For example, two years ago the top issues of the Bell System returned an average 50 basis points more yield than a comparable long Treasury. By the end of 1980, that spread had widened to 175 basis points. OUTLOOK FOR 1981
Inflation will continue to dictate the direction of the markets in 1981. Current estimates for inflation in 1981 are 10 to 11 percent as measured by the GNP deflator.
However, if the Reagan administration is able at least to reduce inflationary expectations, bond yields may fall. It is also important that the government's demand for funds be reduced from current high levels. This can only be accomplished by curbing expenditures and reducing THE deficits. With a tax cut brewing and a probable recession, too, reducing government deficits may be a hard task to accomplish, at least in 1981.
Treasury financing will remain heavy. Corporate financing will be reduced as long as rates remain high. New forms of corporate financing may be tried, such as 15- and 20-year maturities with a sinking fund or an increase in call protection.
Housing demand for mortgage money should be reduced if mortgage rates stay over 14 percent. This should make funds available for other investment instruments. However, if there is a significant reduction on long rates, the total demand for funds will keep long rates in double digit figures.
In such an uncertain inflationary environment, individuals should invest in 1- to 5-year maturities of quality investment. A good size reserve is also advisable. At this point, preservation of one's principle is all important.