Market psychology dropped to its lowest level last week.Prices fell and yields rose to record levels in many instances. The new two-year Treasury note came at an average return of 15.92 percent -- a new record government coupon issue.
A triple-A subsidiary of AT&T, the Diamond State Telephone Co., sold a small issue to return 16.375 percent, a new record for a Bell company. An A-plus rated tax-exempt issue, the Intermountain Power Agency in Utah, sold $222 million 13.00 percent coupon bonds due in 2021 to return 13.07 percent. This is another record for that type of bond.
The quick jump in yields principaly resulted from the large increase in the M-1B monetary aggregate the previous Friday. It surprised market participants and sent Treasury bill rates higher by 75 or more basis points, intermediate Treasury rates higher by 50 or more basis points and long Treasuries up 40 or more basis points.
The federal funds rate, which measures the tightness of funds in the banking system, averaged 20 percent during the week. The release of the aggregates this Friday, however, practically washed out the prior week's increases. The market rallied strongly on this news.
On Wednesday the news was released that the economy as measured by the Gross National Product had declined 1.9 percent, seasonally adjusted, for the second quarter of 1981. Further, the inflation rate as measured by the GNP deflator was up only 6 percent in the April-through-June period. Ordinarily news of this sort would cause bonds to rally, but after a brief spurt upward, bond prices retreated. Again we are seeing the fundamentals being overruled by strong technical considerations.
Perhaps the most revealing insight into the market was Fed Chairman Paul A. Volcker's testimony before Congress this past week. He maintained that the Fed was at the "crucial point" in its battle against inflation and to ease now would destroy their efforts to date.
"There is a persisting skepticism and doubt about the ability of the nation to persevere in an anti-inflation program." The chairman said the battle would be tough, the Fed would dnot give in and interest rates would remain high for the near future.
In light of these remarks and other uncertainties regarding matters such as tax cuts and budget deficits, the one-to-five-year maturity range in all market sectors is a prudent area in which to invest.
Although rates will fall somewhat, they will still be at historically high levels. Continued high rates could lead to a recession, resulting in lower earnings for corporations and lower revenues for municipalities. It would therefore be wise to purchase governments and agencies plus AAA and AA corporates and municipals. New agency issues are returning 50 to 75 basis points more yield than comparable Treasuries. Although FNMA issues are offering a lot more yield, they should be avoided at this time.