The bond markets continued to be battered from pillar to post through most of the week. Prices were volatile but the overall trend was to lower prices and higher yields, as the mood of investors and dealers turned glum and ugly. On Friday, however, the market received a boost when the Federal Reserve supplied reserves to the banking system and the monetary figures showed a decline.
Some say we are in a waffling period, when rates are in the process of changing. It is a period when economic news is mixed, which makes it difficult to discern either the true direction and strength of the economy or the demand for funds. From the markets' standpoint, we are in a period when bad technical forces are overwhelming the fundamental forces governing the market.
Long interest rates peaked in early May and fell through the first half of June. Oddly enough, the federal funds rate, the rate on which most short-term rates are pegged, hit a low of 13 percent at the end of March and then began rising to its current 19 percent level.
During this period the market made a basic assumption that so far has proven erroneous and has cost investors a great deal of money. Wall Street felt that the Federal Reserve would retreat from its credit restraint policy and that a declining federal funds rate would lead short rates, as well as long-term rates, lower. Corporations rushed in to sell their bonds and the buyers were there to buy the high yields before rates move lower.
In much of the new corporate sales, retail customers simply swapped low coupon bonds for the new, original-issue discount and zero coupon issues. The net result was that dealers traded one bond for another and did not reduce their positions.
With the federal funds rate continuing to rise, the cost to the dealers for carrying their long positions also continued rising. Recently, with federal funds trading in the 19 percent to 20 percent range, and with the dealer and broker loan rates charged by banks at the 20 percent level, the losses began to mount for the dealers. Their inventory consists of bonds with single-digit coupons and current 13 to 16 percent coupons. The difference between the coupons on their inventory and the rate it costs them to carry their bonds reflects a loss of anywhere from 300 to 1300 basis points per bond.
Buyers have withdrawn from the marketplace as everyone tries to figure the Fed's next move, or when and if the Fed will ease. The dealers are like desperate people clinging to the edge of a cliff. As their losses continue to grow, they begin to lose their grip and to liquidate their positions at lower prices, hoping to avoid plunging into the void below.
The technical forces of oversupply and little demand have the upper hand now. But sooner or later the fundamental forces of a weakening economy, declining commodity prices, and encouraging inflation numbers should result in an easing in the demand for credit and lower interest rates.