With shortterm rates remaining stubbornly high, the bond market rally has for the time being stalled. A number of factors have been cited as reasons why short rates have remained above market expectations. A strong demand for short-term funds, as measured by the increase in commercial and industrial loans at banks and borrowing in the commercial paper market, is one factor named by analysts. So far this year, these two types of borrowings are up $18.3 billion versus an increase of $4.8 billion during a similar period in 1981.
The problem causing this demand for short-term funds by corporations is high interest rates. During a recession, companies pay down their indebtedness through inventory liquidations and bond sales. But with interest rates so high, the bond market has been mostly closed to many corporate borrowers. Further, the loss of revenue from the recession has depressed corporate cash flows. As a result, the corporations have been forced to dip into their cash reserves, and to borrow from banks and in the commercial paper market, which has helped to keep short rates high.
A technical factor also has helped to keep the all important federal funds rate up around 15 percent. As the Treasury becomes flush with money that flows in from income tax payments in April, it is forced by the sheer magnitude of these flows to place a portion of the money with its account at the Federal Reserve. This drains reserves from the banking system and forces the federal funds rate higher while the Fed tries to offset this tightness by supplying reserves to the system.
As the Treasury spends this tax money, it draws down funds from its account at the Fed and the whole precedure is reversed. Dealers had hoped that the process would now move the federal funds rate lower, but for some unclear reason, the rate has remained around 15.00 percent. This Monday, dealers will have to pay for the recent $9.5 billion refunding, which will place more pressure on the banking system and should keep the federal fund rate up.
Since 1980, there have been five bond market rallies, but the only real sustainable rallies have occurred where the yield curve has become decidedly positive with short rates of declining way below long-term rates. And that has happened only twice since 1980. A Treasury yield curve is derived by plotting the yields of various maturities at a given time, say three months or two years out to 30 years.
If the curve is higher in the shorter maturity it is considered a negative yield curve. If more yield is available in the longer maturities, it is considered a positive yield curve. The economy needs a positive yield curve to right itself during a recession. Currently, the yield curve remains negative (13.92 percent in two years versus 13.24 percent in 30 years). So unless short rates fall to where the yield curve becomes decidedly positive, it is highly unlikely that the rally will be sustained, nor will we have a healthy economic recovery.
The lower level of interest rates at the beginning of the week prompted several corporations to offer almost $1 billion in new issues. The tax exempt calender was light last week, but through the month of April $19.3 billion of new municipals have been sold, up to 35 percent over a similar time in 1981. Closed end bond funds and unit investment trusts continue their insatiable appetite for high yielding long-term municipals.