The month of May has witnessed a dramatic shift in the Treasury-yield curve that should bode well for corporate borrowers. A yield curve is obtained by plotting the returns on various maturities--from the shortest to the longest--at any given time. In early May the three-month T-bill returned a bond yield equivalent of 13.28 percent while the 30-year bond returned 13.44 percent. If an investor were to sell the T-bill and lengthen into the bond, he would pick up 16 basis points of yield. (A basis point is 0.01 of a percentage point.)
By the end of May, the three-month T-bill was returning a bond-yield equivalent of 11.82 percent, while the long Treasury returned 13.40 percent. Consequently, a shift to the long bond would result in a pickup of 158 basis points of yield. In effect, the yield curve has become more positive, as opposed to the negative curves we have lived through during the past 2 1/2 years. With a negative curve the yields on the shorter maturities are much higher than the returns on the longer ones.
And this phenomena resulted in the popularity and growth of the money market funds. The latest weekly figures on the money market funds show a growth of $3.7 billion to an all-time high of $200 billion. This huge growth occurred because the returns on the money market funds lag the declines of the individual money market securities. So while the three-month T-bill is returning 11.82 percent, the Rowe Price Prime Reserve fund is returning 14.02 percent.
The dramatic change in the curve occurred because short rates have declined significantly more than long rates, especially during the past two weeks. For instance, the three month T-bill has fallen 146 basis points while the 30-year bond has declined by only 4 basis points. Two factors are responsible for these short-term declines. First and most important, the Federal Reserve has given every indication that they have allowed reserves to be more plentiful in the banking system. This in turn has caused the key federal funds rate to decline about 200 basis points through May. The cost of dealers financing their positions has similarly fallen--in this case, by 125 basis points. With these key rates heading down, all the other short rates followed.
The second reason for the decline in short rates was the Drysdale government bond fiasco, coupled with the rumored collapse of International Harvester and the actual bankruptcy of Braniff. Investors became acutely concerned with their various short-term investments, especially commercial paper, which is issued by corporations, as well as the viability of doing overnight repurchase agreements with government dealers. This triggered a great flight into quality securities. T-bills have benefited the most, caused by an almost insatiable demand for this short-term government paper. That's why the yields plummeted 146 basis points on three-month bills to only 75 basis points on three-month certificates of deposit.
But the money market has stalled out here, and it will take further action by the Fed to lead short rates lower. The Fed has shown us some light; now they must confirm a new level by allowing the federal funds rate to fall to 13 percent if the rally is to continue. At the same time, hopefully a window will be opened to the corporate market and corporations will be able to fund their immense short-term debt into longer maturities. But this action has to be done quickly and with the help of lower long-term rates, because the issuers are many and the Treasury will start financing in earnest this summer. Last week, the corporate window opened enough to allow a face amount of $1.4 billion of new issues to be sold.
The new-issue municipal market floundered this past week due to the noticeable absence of buying by closed-end bond funds. The recent Washington Public Power Supply revenue issue was still available at such cheap levels that the closed-end funds couldn't put anything together to compete with the revenue issue. So they wisely stayed out of the market and the new issue sold poorly.