The fixed-income markets continued to improve in the face of light overall retail activity. Retail investors did purchase the new issues and the new Treasury seven-year note was well received, with an average return of 15.4 percent. A spurt in prices occurred Thursday afternoon as professionals began to cover their short positions in Treasuries in both the futures and cash markets before the three-day weekend. Since the markets are extremely thin and there is little supply, prices rose and yields tumbled. The rally continued through Friday, aided by lower money supply numbers and a cut in the Federal Reserve discount rate surcharge.
Short-term rates continued to decline as the federal funds rate -- the rate banks charge for the use of their free reserves -- fell to the 12.50 percent level on Tuesday, which would indicate an excess of reserves in the banking system. Over the next few days the Fed drained reserves from the system, causing the federal funds rate to return to the 14 percent area.
Basically, the market is fluctuating because of expectations. The recent dreary economic news is bullish for the bond market because with slower business activity there is a lessening of demand for credit. If the demand for credit falls, so will interest rates. For those investors who foresee a continuing decline in business activity, perhaps a recession, bonds at these levels look most attractive.
Counter to this philosophy are those who feel the large federal budget deficits that must be financed along with the huge, pent-up demand for capital from corporations and municipalities will eventually keep interest rates from falling too much farther. Besides, these bears say, the economy will not go into a recession, and any stimuli from an easing of credit by the Fed, from the tax cuts or from increased defense spending will cause the economy to improve and spur a further increase in the demand for credit.
Caught between these two positions are the Federal Reserve and the Reagan Administration. Both have a great deal at stake. Administration officials are calling for the Fed to supply more reserves to the banking system so that interest rates will fall, business will be revived and fresh life can be breathed into a stagnating economy. The Reagan economic plan was built on the expectation that the economy would recover quickly and expand. High interest rates have thwarted those hopes. In fact, the high rates are largely responsible for the administration's low estimates of the budget deficits.
The Fed, on the other hand, believes the inflationary forces that have been building up in this country over the past 15 years cannot be curtailed overnight. Chairman Paul Volcker does not want to repeat the previous errors of other Fed officials and pump money into the banking system when the economy begins to falter. In the past such action has led to lower interest rates and in time, higher inflation. The chairman is adamant in his position, while a frustrated administration sees the success of its dicey, supply-side economic program hanging in the balance.
Because of this and the congressional elections in 1982, a classic confrontation, with the Federal Reserve on the one side and the administration and Congress on the other, is fast becoming a political time bomb. A cynic might say the recent remarks from the Treasury could be aimed at setting the Federal Reserve up as the scapegoat in the event the new economic program fails.
In response to the All Savers certificates, Merrill Lynch, Dean Witter Reynolds, Bache Halsey Stuart and Shearson, hope to market on Oct. 20 a floating-rate, municipal investment trust fund. According to the prospectus, the fund will consist of "a fixed portfolio of municipal bonds, each guaranteed by or backed by a letter of credit from some of the nation's major banks."
Units will be available at about $1,000 each. Interest payments will be made monthly, and the tax-free rate of return will be figured at approximately 60 percent of the prime rate at major banks. At today's 19 percent prime, the return would be 11.40 percent. The idea of the fund is to preserve principal, offer liquidity and tax-free income. Consult the underwriters for more details.