There is a great deal of uncertainty about what will happen with interest rates.
When the economy is on the verge of moving from one phase of a cycle to another, confusing signs abound. For instance, industrial production is continuing to decline, while home building is improving. As long as the economy moves from recession to recovery or somewhere in between, economic data will continue to be mixed, and the course of action for bond investors will remain uncertain.
The Federal Reserve's course of action contains large pitfalls as well. In fact, one wonders if the Fed isn't finding itself cornered once more. The weak economy and the reduction of inflation argue for lower interest rates to revive the economy. On the other hand, the rapid growth of the reserve aggregates and the money supply signal caution for allowing rates to decline and could possibly call for higher rates before fears of a revival of inflation occur.
On top of that lies the problem of the massive federal budget deficits projected for the next several years. Fortunately, interest rates have been declining since June, and the Treasury has been able to sell its debt at declining rates rather easily. Given the present condition of the economy and the low inflation rate, financing these deficits would not ordinarily be inflationary and should not cause interest rates to rise. However, financing the deficits would become inflationary if the Fed were forced to purchase, or monetize, the debt.
That has not yet happened. But if enough investors perceive the continuous deficits as being inflationary, interest rates will probably have to rise to induce buyers to purchase the unending stream of Treasury issues.
The politicians are telling us that interest rates must come down further in order to sustain a recovery. Now the question is being raised concerning the third leg of the administration's tax cut. Should it go through in July, should it be moved forward to January, or should it be done away with all together? What effect would each course of action have on rates? Still more uncertainty.
Finally, where are we in the bond market rally -- 60 percent through, 80 percent through or what? When considering all the aforementioned it is understandable why a bond investor may be uncertain as to what to purchase, whether to take profits, whether to buy discount bonds or whether to buy long or short maturities.
The Treasury market seems tired, but continues to look for the "quick fix" of a discount rate cut. Last week rumors of an imminent cut surfaced daily until the reduction finally became a reality late Friday. It would seem that the market tried to wish prices higher all week.
The municipal market continues to perform amazingly well and still offers attractive, tax-free returns relative to the taxable market. During the past two weeks alone, at least $5.5 billion in new issues were sold -- a record. The long bonds proved so enticing that buyers who only purchase taxable bonds stepped in and purchased some long tax-free hospital issues. In fact, when compared to long Treasury issues, the ratio of the yield on an AAA-rated tax-exempt issue versus the yield on a similiar Treasury bond (9.60 divided by 10.50 equals 91.4 percent) is close to the all-time high in the 15 to 20 and 30-year maturities. This means that tax exempts in those maturities are exceedingly cheap versus the Treasuries.
On Tuesday the Treasury will sell a five-year note in minimums of $1,000. They should return around 10.15 percent.