Wall Street was swept by a swirling wind from Washington that directly affected the bond markets. As bond prices continued slumping, senators and representatives returned to work from their August recess with their constituents' angry complaints concerning high interest rates ringing in their ears.
From Capitol Hill came talk of budget cuts, curbing the Federal Reserve, controlling credit, returning to the gold standard and even a windfall profits tax on those who lend money at a specified percentage over the inflation rate. This touched the traders on Wall Street, who, acting on the premise of "where there's smoke, there's fire," quickly began to cover their short positions in both the financial futures market and in the cash market. Since the bond markets have little liquidity and depth now, prices quickly rose and a minitechnical rally was on.
The questionable opinion seems to be that many bond traders and a few investors are betting that some action out of Washington will calm the credit markets and cause interest rates to decline. However, it will be extremely tough for the Reagan administration to obtain all the budget cuts it needs to lower the deficits, and the Federal Reserve would lose its credibility if it began easing credit at this juncture.
The problem with the budget deficits are real. In their early forecasting, the administration miscalculated the strength of the economy, inflation and how long interest rates would remain high. As a result, they missed $10 billion a year in revenue and will have to pay an additional $8 billion a year in interest on the federal debt. This means that regardless of what happens during the next three years, an additional $18 billion in deficit has been added to the administration's initial projections. The huge tax cuts and the miscalculations have locked the administration into fairly large deficits at least through 1984 and probably 1985.
But large deficits can be financed in the right environment, and size need not be a deterrent. But in an environment where there are high real interest rates and no one knows what the Fed will do rates tomorrow, investors hesitate and purchase very short, safe maturities.
Interest rates are high because the Fed wants them high. The Fed refuses to monetize the debt; that is, provide the extra money through the banking system for the purchase of the federal debt. This forces up rates, which in turn attracts investors to purchase the debt in the form of Treasury securities.
Consequently, a crowding out of borrowers has occurred from two directions. First, the Treasury, by the sheer size of their needs and because they can pay any interest rate necessary to obtain their funds, completely dominates the credit markets.
At the same time, the high rates also crowd out less credit-worthy borrowers, who cannot afford to pay 15 percent or higher for their funds.
With these high real interest rates, we are really in the midst of a subtle credit crunch. Since policy is unlikely to change in the short term, the only relief will probably come from a genuine economic slump, which may be on the way.
Interest rates on short-term municipals continue to surge. Government-backed project notes were offered at 10 percent, while it took a 13 percent return to sell one note for the state of Michigan. The state of Pennsylvania will sell $450 million in 10-month notes Tuesday. More note issues are on the way.
The Treasury will auction a two-year note Wednesday in minimum denominations of $5,000. A possible price level will be 16 1/4 percent