The purpose of this article is to suggest to the fixed-income investment or that now is not the time to buy long bonds. Conversely, short-term investments, like money market funds or Treasury bills, are the safest place to be.
The recent rally was caused by the expectations that high interest rates would slow the economy, curtail the huge demand for credit and cause inflation to recede. The Federal Reserve would then play its part in loosening the tight credit reins.
Unfortunately, recent economic news shows that there is still steam left in the economy. The fact that the Gross National Product was up 5 percent in the fourth quarter of 1980 surprised one and all. So far there has been no real evidence that the economy is headed into a recession. As investors realized this, bond prices began to decline and an already jittery market became more jittery.
The new administration now finds itself in a dilemma. They promised a supply-side approach to our economic woes and one facet of that approach is tax cuts.
The problem arises in that the budget deficit in fiscal year 1980 was $59.2 billion, and so far this fiscal year, the deficit at best will be $59 billion. This red ink must be financed through the Treasury market which is placing increasingly larger demands on the nation's funds. In effect they are crowding out the borrowers from the private sector since they can pay any interest rate and must get their money.
But the problem gets worse. A tax cut stimulates the economy as corporations and individuals have more money to spend. Currently the economy is not in a recession and it may be a few months, if ever, before the economy goes into a recession.
On the other side, tax cuts mean less revenue for the government. This increases the size of the deficits as the government continues to spend more money than it takes in.
The bottom line is that both tax cuts and increased government spending will stimulate the economy. Added to this is the pledge to increase military spending. Consequently the possibility to cool down inflation appears more remote. And remember, as the economy begins to do better, credit demands rise, the Fed will tighten, inflation will still be high, interest rates will begin to climb and bond prices will fall.
The administration will try to temper all of this by making corporate tax cuts retroactive to Jan. 1, but individuals will not benefit until mid-summer. cThis way some of the revenue shortfall can be put over into the next fiscal year.
On top of all this, the Treasury still has to raise around $25 billion in this quarter. Corporations are financing heavily now, because they need to adjust their balance sheets. But the retail buyer is not buying, especially since facing a bleak interest rate outlook.
Consequently rates will rise even more, since the government has to raise so much money in the next two months. Buyers must be enticed into the market with higher rates.
As I said earlier, stay short as long as there is no real downturn in the economy. Protection of principal is all important. As long as short rates remain considerably higher than long rates, it will be almost impossible for there to be a rally in the long bond market.