Interest rates were extremely volatile in 1981. Long rates as measured by 30-year Treasury bonds peaked on three separate occasions during the year. Each successive peaking occurred at a higher level: 13.19 percent in February, 13.83 percent in May and 15.08 percent in September. Similarly, short rates peaked on three occasions, but in the months preceding the peaking of long bonds.
John Paulus, financial economist at Goldman Sachs, attributes the new heights in interest rates to the deregulation of the financial system, combined with a tight monetary policy along with the volatility of bond prices.
With deregulation, the usury ceilings on mortgages and installment credit were eliminated. The ceiling imposed on the rates that banks could pay on time deposits was also lifted. In the past, when the Federal Reserve pushed market rates above these ceilings, it became unprofitable for financial institutions to borrow at high rates and lend at lower rates. The incentive to make these loans diminished, and the demand for funds by banks and thrifts fell. Eventually, economic activity slowed. All this was accomplished when interest rates were slightly above the ceiling and necessitated a real interest rate of only 1 percent to 2 1/2 percent.
When the ceilings were removed, there was a need to get real interest rates high enough to choke off the demand for credit. And since interest payments were tax deductible, it became necessary to get the real after-tax rates high enough to bite. It therefore took an increase in real rates of to 700 to 900 basis points to slow down the demand for credit and the economy.
This, combined with a tight monetary policy that restricted the availability of reserves in the banking system, which in turn limited the growth of credit, helped to push rates to record levels. And since bond prices were so volatile, investors demanded an interest rate premium to compensate for the risks involved in holding bonds. This, too, helped to force bond rates higher.
In light of the deregulation and the Federal Reserve's continued tight monetary policy, short-term interest rates remained at extremely high levels through most of the year. In fact, short rates were higher than long rates through October, righting themselves in mid-November. Investors were paid handsomely to keep their funds in short securities, while the borrowers paid dearly to obtain funds.
Bankers' acceptances, which are negotiable time drafts used to facilitate world trade, grew 19 percent to a new high of an estimated $68 billion outstanding.
High long-term rates forced corporations to borrow in the short-term commercial paper market most of the year. The amount of paper outstanding reached a zenith of $167 billion in November, up 36 percent from 1980.
Banks obtain needed funds, which they re-lend, through the issuance of certificates of deposit. During 1981, the volume of outstanding CD's grew 18 percent to $135 billion.
The money market funds continued their phenomenal growth even though short-term interest rates were declining through the last five months of the year. These funds grew from $75 billion in 1980 to $185.5 billion, an increase of 148 percent. Tax-exempt money market funds also prospered, doubling from $2 billion to $4.5 billion by year end.
It was another rocky and volatile year for the government bond market, which witnessed the growth of the outstanding public debt to more than $1 trillion. Although Wall Street and most investors liked many parts of the new Reaganomics program, many failed to realize that it required time to get the supply side operation in place. They also failed to realize that cutting taxes to get the new program moving created instant deficits, much larger than would have otherwise been the case. It wasn't until the middle of the year that the size of the potential deficits began to surface. This resulted in the Treasury market falling hard, caused mainly by the spectre of too many bonds in the future.
The Treasury unofficially had gross financings of $635 billion. Of that amount, $96 billion represented new money; $20 billion of this new money came from off-budget items and was financed for the Federal Financing Bank through Treasury offerings.
The three leading federally sponsored agencies, the Federal Home Loan Bank, the Federal Farm Credit Bank and the Federal National Mortgage Association, borrowed approximately $26 billion of new money during 1981, up slightly from $25 billion in 1980. GNMA increased the amount of its mortgage pass-through securities to $127 billion, up 13 percent.
The municipal market suffered a precipitous sell-off over much of the year and was buffeted from several directions--the advent of the "All Savers" certificates, the reduction in marginal taxes from 70 percent to 50 percent, and the absence of several major institutional buyers from the market.
But the market showed its ability to withstand adversity, and by yearend to become historically much more attractive to buyers relative to taxable securities. In fact, on occasion, the long electric revenue issues returned as much as 110 percent of the yields available on long Treasuries. And the short end of the market adjusted to where individuals in the 40-50 percent tax bracket could afford to own short-term municipals or tax-exempt money market funds. This was not true earlier in the year.
New York City, meanwhile, made its reentry into the bond market in 1981, borrowing through its own credit for the first time since 1975. In recent years, state funds were segregated and used to back the city's offerings.
The 1981 new issue volume of $45.3 billion fell short of 1980's record calendar of $47 billion. Revenue issues grew to 69 percent of the total amount of bonds sold, up from 64 percent in 1980. In spite of a surge in municipal housing issues in November and December, this segment of the market declined from 30 percent in 1980 to 15 percent in 1981.
The problem facing corporate issuers was how to sell longer maturities in an atmosphere of rising interest rates and few buyers. When rates turned lower, the markets then had the additional problem of too much supply for an uncertain demand. This uncertain demand was based on the proposition that investors were not all that convinced that any rally would have longevity.
Due to the heavy buildup of supply, innovative financing became important. Wall Street responded with "original issue discount" bonds, zero coupon bonds, and issues sold with warrants to purchase zero coupon bonds.
Supply will continue to be a problem, especially for a market where investors have become trading oriented, more interested in capital gains than in buying for income.
The surge of new issues during the last quarter of 1981 ($15.5 billion) lifted last year's output to a record $41 billion. Besides the flood of original issue discounts and zero coupon issues ($4.3 billion actual dollars raised), most of the new maturities (56 percent) were 10 years or less, while the volume of new BAA credits or lower that were sold was the same as in 1980, at 15 percent.
This promises to be another roller coaster year for interest rates. We are beginning the year in the midst of a recession that should pull rates down. Once the economy recovers, chances are that rates will rise with the renewed demand for credit. And all the major borrowers will be in line to obtain much needed funds.