An immensely important high-stakes drama is unfolding in the U.S. Treasury bond market. The conclusion is far from certain, and in turn, this uncertainty is creating a very nervous market. For the economy to recover, interest rates, both nominal and real, must decline even further. Basically, a low inflation rate, weak short-term credit demands and the efforts of the Federal Reserve would ordinarily accomplish this rate reduction task.

However, this time around, the Treasury is faced with selling an ever-growing supply of debt to finance the federal budget deficits. To accomplish this chore, the Treasury has been forced to increase the size of its new issue offerings. Last June, the weekly three- and six-month T-bill auctions totaled $9 billion. This past week, these issues had grown to $12 billion. Similarly, last June, $5.5 billion of two-year notes were sold, while this past Wednesday, $7.5 billion of the new two-year notes sold. From a greater perspective, the Treasury must sell, from Jan. 17 through Feb. 28, $135 billion of securities, of which only $7 billion will be longer than five years.

Currently, the government dealers are carrying large positions of unsold bonds. They have been hoping for a cut in the Fed's discount rate to help push rates lower and create a demand for their bonds. To carry these large positions, the dealers generally enter into repurchase agreements with customers who carry the dealer's position overnight. Recently, the dealers have paid their customers 8 1/4 percent--the repo rate--to carry their securities. If, for example, a dealer has a 9 1/4 percent note in position, the dealer would earn 100 basis points, which is the difference between the repo rate of 8 1/4 percent and the 9 1/4 percent coupon.

This is known as a positive cost of carry. In stable times, this is a good cushion for a dealer, but in uncertain times, it's very difficult to decide on what is a good cushion. Consider the dealer who is carrying a $1 billion bond position. If the price of the bonds drops 1/32, that represents a paper loss of $320,000 to the dealer. The point is, dealers are loath to take on more inventory in questionable periods.

Consequently, with the tidal wave of new Treasury offerings engulfing the market, and with a mediocre investor demand for the securities, one might seriously ask the question, is the Treasury crowding itself out of the market, especially in the very short maturities out to five years? If this in fact is the case, then interest rates will have to move higher to attract more buyers of the Treasury debt, which is completely counter to the Fed's desire to see rates fall. This leaves the Fed with but two alternatives, supply more reserves to the banking system in hope of forcing the banks to purchase more of the debt or, for the Fed to purchase some of the debt itself.

This latter event, which is known as monetization of the debt, is considered inflationary and in the long run will push long-term rates higher. In fact, the market has begun to perceive this "Catch-22" situation. This, coupled with the uncertainty over the coming budget deficits and the expected upturn in the economy, is creating additional uncertainty for the market. Long Treasuries have fallen in price while investors have begun to shorten maturities.

Other alternative investments are also creating problems for the Treasury market. About $30 billion has flowed from the money market funds since banks and thrifts began offering new money market accounts in December and Super NOW accounts in January. At this point, it is unclear just how much has flowed into these new high-rate insured accounts, but probably little has gone to the much lower yielding Treasury issues.

Other investors who were in bonds in 1982 have taken their profits and have been lured into the stock market. In short, bonds are not the only game in town anymore and are losing their investor appeal, especially at these lower interest rate levels. All this bodes ill for the Treasury and for the march toward lower interest rates.