The bond markets will be affected by three separate events that occurred last week. But to what extent will be unknown for many months.
The first two events were the passage of the administration's tax cuts by both houses of Congress. And to everyone's surprise the administration's economic package has evolved practically unscathed from its initial presentation.
This tax legislation will effect the bond markets either positively or negatively, depending on the amount of stimulus to the economy and depending on the size of the deficits created in the next few years. At this point these are unknowns.
In the real world the Federal Reserve appears to have the money supply under control, the economy has slowed appreciably, while many say we're headed for a recession and at the same time all the inflation indices have fallen to single-digit numbers. And where are interest rates? Higher now than when the new administration took office in January.
This paradox is being caused by investors looking at the possible inconsistences between a fiscal policy designed to stimulate the economy and a monetary policy whose purpose is to restrain the economy by limiting the growth of the money supply in the system. If the economy is growing much faster than the amount of money supply available, interest rates will rise to prevent the money supply from exceeding the growth limits set by the Fed.
The other event from last week, whose outcome will be known quickly is the Treasury's $8.5 billion quarterly refunding. This will feature a 3 1/4-year note to be auctioned on Tuesday with minimum denominations of $5,000; a reopening of the 9 3/4-year note -- the 14 1/2 percent due May 15, 1991, which will be auctioned on Wednesday and the reopening of the 29 3/4-year bond -- the 13.87 1/2 percent due May 15, 2011 -- to be auctioned on Thursday. The latter two issues will be available in minimum denominations of $1000.
A guide to the possible returns in order of their sales would be 15.55 percent, 14.6 percent and 13.88 percent.
At the refunding brief Treasury officials announced the "possibility of temporarily suspending long-term bond issues at some appropriate time in the future." We feel that to tamper with the long-term market would be a big mistake.
Due to the quarterly offerings of long bonds plus an occasional 15-year or 20-year bond, liquidity has been developed in that sector of the market. Because of this liquidity many institutional investors buy and trade long Treasury bonds.
Long Treasuries are also a most important linchpin for the corporate bond market since all long corporate bonds are priced on a yield spread off the Treasuries. Consequently, if long Treasury issues were to be stopped, the beacon for the corporate pricings would be gone plus the liquidity factor that has evolved in that sector of the market over the years. And so buyers of these long Treasuries would also vanish.
Eventually the Treasury would have to finance in another maturity area. Currently many corporations are financing in the 5- to 10-year area, and should the Treasury decide to muscle in on that sector, corporate borrowers would be hurt.
Finally, only approximately 10 percent of the Federal debt matures beyond 10 years while some 40 percent matures each year. If inflation and interest rates decline, the Treasury is in a good position to extend more of the debt at a lower cost. So why take a chance on fouling up the capital market anyt more than it already is, to say nothing of the problems of having the average maturity of the $656 billion marketable debt fall below the current 3 years, 11 months.