The bond markets suffered through another chaotic week in which the technical conditions simple stiffled the market. A diagnosis of the problem would be a large case of indigestion.
Around $18 billion of new issues of agencies, Treasuries and corporates inundated the market. Buyers remained skeptical and stayed on the sidelines. As a result the dealer positions swelled with unsold bonds.
Confusion concerning the Federal funds rate and the true direction of Federal Reserve policy still mesmerized the market. Uncertainty continues as to why the Federal Funds rate -- the rate at which banks lend their excess reserves to one another -- still was gyrating around. But one of the most plausible explanations is as follows:
Banks raise funds by selling large amounts of certificates of deposit. In fact $44 billion were due to mature during June. The banks are able to lend this money but they must do so at rates higher than they are paying on the CDs. So interest rates are a crucial factor.
The market anticipated that rates were going to decline and, rather than issue the maturing CDs at high rates for one to six months, the banks decided to borrow through a short-term source of money, the Federal funds market. Then when rates had declined they would sell new CDs hopefully at much lower rates.
At the same time the bond dealers, also feeling that long rates were going to decline and expecting a good rally, began to increase their inventory positions. But these positions had to be financed. A major source of that financing is through overnight dealer loans arranged with larger commercial banks.
Concurrently with this shifting in demand to short-term funds was the changing attitude of the lenders who usually provide or lend funds to the short-term market. It was tax time for the large corporations and they withdrew funds from the short markets to pay Uncle Sam. Further, other short-term investors anticipating a decline in rates, had embarked on lengthening their maturities so that they could own high returns for a longer period of time.
The end result was that the demand for short-term money was much greater than the supply of available funds that caused short-term interest rates to go sky-high. This has thoroughly confused and dictated the direction of the market over the past two weeks. But it was felt that once the Federal funds rate declined, the bond market would improve and that decline was imminent.
The dealers kept their large positions. Finally when the funds rate began to decline, they found themselves awash in new issues and surrounded by skeptical buyers who adopted a wait-and-see attitude. Consequently, market prices declined even in the face of a lower Federal Funds rate.
Several municipal and corporate issues were postponed and the market knows that we will be plagued with a supply problem. It will take decisive action on the part of the Federal Reserve to break the current logjam. With this sort of action unlikely, we probably will see a floundering market with a bias towards lower prices. If this occurs, it should be time to purchase more bonds in the one- to five-year maturity range.
The Treasury will offer a seven-year bond on Tuesday in minimum denominations of $1,000.