At the beginning of summer, a variety of economic and financial problems faced the people of the United States. One thing was certain -- that the economy would not recover as long as real interest rates remained at historically high levels. The question then became, how do we get interest rates down from these levels?
As the summer wore on, several economic realities became obvious. First and foremost was the renewed weakness in the economy. Allied with this weakness was the downtrend in the growth of the money supply. These two weaknesses allowed the Federal Reserve the opportunity it needed to bring interest rates down. The Fed began to supply more reserves to the banking system; then came a lowering of the discount rate, followed by a continued supplying of reserves and two more discount rate cuts. Finally, as last week began, the last of the "bad news bears," two economists, Albert M. Wojnilower of First Boston, and Henry Kaufman of Salomon Brothers, both capitulated on their high interest rate scenarios on successive days and predicted that rates would fall to much lower levels over the next 12 months. That was the spark that greatly accelerated a mild bond rally that had been in progress and also led to a dynamic but questionable rally in the stock market. Questionable because both gurus based their interest rate forecasts on the premise that the economic recovery would be extremely weak, which translates into flat corporate earnings.
Panic buying emerged in the fixed income area; everyone had to own bonds. In this atmosphere, the investment bankers supplied all the corporate bonds they were able to market to investors. The new issue volume for the week totaled $3.5 billion, second only to the $4.08 billion week of 11/16/81. The overwhelming amount of the new issues had maturities of 10 years or shorter following the financing pattern of the past several months.
The interest rate declines have been rapid and widespread. Following the Mexican peso crisis that surfaced Thursday, the continued flight to quality drove the current 3-month T-bill down to 7.00 percent, a decline of 225 basis points since the beginning of August alone. Long Treasuries are bouncing around 12.05 percent, off 140 basis points for the month. The Bond buyers 20 bond municipal index declined 104 basis points in just this last week.
These dramatic rate declines pose many new questions for investors. Are the recent declines in interest rates cyclical -- part of a 3- to 5-year trend, or are they secular -- the beginning of a long-term move to lower interest rates? The answer to those questions are crucial to whether or not an investor purchases short-term or long-term bonds.
What will unit-holders of money market funds do after they have witnessed their yields drop from 13.75 percent in mid-May to single digit rates in the next few weeks? Will they lengthen into marketable securities, switch to a bond or stock fund, or just stay put? The decision here could be crucial to the direction of rates, especially if investors extend maturities. Or, will money flow back into the thrifts, especially when a return of 13.00 percent is still available on the 30 month small-savers certificate.
How long will the Fed be able to allow interest rates to continue to fall or to stay at these lower levels? A direct product of lower rates is the increase in the growth of the money supply, which currently has an upper limit of growth of 5 1/2 percent. The Fed has already told us that it will permit the money supply to grow above that upper limit during the second half of this year. But suppose there is an explosion of the money supply growth that greatly exceeds that 5 1/2 percent limit. Can the Fed risk another surge of inflation by keeping rates low or will it be forced to raise rates to control the situation?
In essence, investors must rethink where they are in this whole new interest rate environment that is still saddled with many of the old economic and financial problems. Investing won't be easy anymore, and it could be quite treacherous.
This week will see a large calendar of high-grade general obligation tax exempt issues, including the states of California, New York, Massachusetts and Wisconsin.
The Treasury will offer a 2-year note on Wednesday in minimums of $5,000. They could possibly return 11 percent.