Bond yields seesawed back and forth around record high levels throughout the week. Just as fast as the returns on long Teasuries would puncture record levels, they would quickly retreat as traders attempted to purchase bonds at the new peaks. Since the markets are extremely thin, a little buying pressure or a little selling pressure would push prices quickly in either direction.
However, a stream of poor economic figures released during the week resulted in a strong rally on Friday.
But as we enter the final quarter of the calendar year as well as the first quarter of fiscal year 1982, the financial markets and the economic system are facing monumental problems. It is the disposition of these problems that will determine not only the direction of interest rates in the future, but the very social fiber of the country as well. For many of the administration's programs are aimed at reversing the country's drift into being a welfare state. And such reversals will be painful to many.
Two major problems facing the financial markets in particular are inflation and the prospective budget deficits. Bill Griggs, a stellar economist from Shroder Bank and Trust Co., points out, "regardless of what happens to inflation, approximately $70 billion in deficits must be financed over the next six months." Griggs emphasizes, "the main reason why inflation has improved recently is due to the decline in food and fuel prices and such declines should continue into 1982. But to be more effective, these types of declines must spread into other areas like the wage settlements that will take place in 1982."
Chase Manhattan's highly regarded economist, Phil Braverman, sees the problem of the deficit as being twofold. First the deficit contributes to a greater level of inflationary expectations which he estimates the market sees as being 13 percent to 14 percent for the decade, despite a current inflation rate of around 8 percent. Braverman arrives at this expected inflation number by working backwards from a 17 percent interest rate currently available in the bond market. A 3 percent real interest rate plus a 1 percent risk premium is deducted to arrive at the 13-14 percent expected inflation figure. And this is why interest rates remain high today.
Braverman also points out that the markets interpret the deficits "as an indication of our inability to put our financial house in order, which in turn contributes to inflation." The end result is a "negative psychological impact on the market's expectation of the ability of the government to deal with the inflation problem on a long term basis."
Both economists feel that there is a good possiblity the economy could fall into a serious recession. But with fiscal policy being stimulative from tax cuts and increased defense spending and monetary policy being restrictive, both felt that something or someone would have to give. Either the Federal Reserve will back off and allow interest rates to fall a prescribed amount, or Congress will have to validate the administration's second round of expenditure cuts, or they both hold firm and the markets will continue to deteriorate further.
With these uncertainties in mind, most investors should limit their fixed income purchases to the high returns that are available out through five years. Preservation of one's principal is all important. An investor can always lengthen maturities if more favorable economic and financial scenarios unfold.
The Treasury will sell a seven-year note on Wednesday in minimums of $1,000. On Tuesday over $2 billion in government backed (HUD) tax-exempt project notes will be offered. Most of the maturities will be in March, April and May of 1982. Returns should around 9.5 percent.