The figures above certify the dramatic decline in interest rates that has occurred since mid-June. The usual pattern in a sustained rally is for short-term rates to decline first and at a steeper rate than long-term rates. This rally has followed true to form, with short-term rates making about 60 percent of their decline from mid-June until the end of July, with the remaining decline in August. The exception to this is the dazzling drop in short Treasury bill rates that was caused by a flight to quality brought on by a host of financial crises. In the case of the T-bills, over 60 percent of the rate declines occurred in August. On the other hand, 60 to 70 percent of the rate declines in long bonds has occurred in August.
The drop in short rates has helped to create an extremely positive yield curve. This means that the yield spread between the three-month T-bill and the 30-year Treasury is exceedingly wide, 530 basis points. Normally in such periods, that spread would be around 275 basis points. To conform to historic standards, either the T-bill rates will rise or long rates should decline. More than likely, both will happen.
The Schroder Report recently pointed out that this sharply positive yield curve will enable the Treasury to finance its huge deficits so that government dealers will have a positive carry-profit to help them underwrite the government debt. For example, they can finance their positions at, say, 7 percent, while earning 11 percent from the coupon on their inventory.
This extremely positive yield curve will also aid corporations in refunding their short-term indebtedness, currently outstanding in the form of commercial paper and bank loans. It should, therefore, come as no surprise that, with interest rates falling since mid-June, corporations have sold over $10 billion worth of bonds, or 40 percent of this year's supply. About 60 percent of this year's financings has been with maturities of 10 years or less. Investment bankers believe that if interest rates stabilize at these lower levels, and if investors become convinced that it is worth their while to extend into longer maturities for the large pickup in yield, then corporations will be able to sell a much greater amount of long corporate debt.
With all of the interest rate declines, Elliot Platt, an economist for Donaldson, Lufkin & Jenrette, believes that the most crucial event now is "how fast the economy will respond to the lower level of interest rates and the tax cut." He further believes that "the Fed will wait and see if the current interest rate levels are adequate to turn the economy around," and, therefore, Platt expects nothing dramatic from the Fed in the near term.
The Treasury will offer a five-year note on Tuesday, in minimums of $1,000. They will probably return 12 1/2 percent. A one-year bill will be offered by the Treasury on Thursday in minimum denominations of $10,000.