If the bond market was hoping for insight into Federal Reserve policy, it came up shorthanded from Chairman Paul Volcker's testimony before the Senate Banking Committee on Thursday. The fault was not so much with the chairman's testimony, but more with the less-than-penetrating questions asked by the members of the committee.
However, some rays of light were shed on the situation. As some pundits had felt, the Fed has been a little more restrictive in recent weeks in dealing with the banking system. This has helped to move the federal funds rate, which measures the cost of overnight money, higher. In fact, the federal funds rate has risen about 75 basis points since mid-May and in turn has influenced all other short-term market rates to move up.
Volcker also indicated that the money supply aggregate M1 was still not the most important aggregate in the determination of monetary policy. This jibes with what economist Sam Nakagama has held. In fact, Nakagama believes that the aggregates M2 and M3 are within target while growth in M1 has slowed. This means that the Fed need not tighten the credit reins any further for now. Consequently, Sam also feels that in its present state, the government bond market is oversold.
As Volcker's testimony was released, the market bounced up and down. Investors were not so sure of their convictions as was Nakagama. In fact, many dealers were whipsawed in the price changes before the day was out. Trading is not the playground for those of gentle heart.
One rate that is often misunderstood is the prime rate. The prime is an administrated bank loan rate, as opposed to a constantly changing market rate. It is the base rate from which other bank lending rates may be calculated. It is a specious rate in that although it may be the posted rate, it may not be the actual rate a borrower will be charged.
For example, if the XYZ corporation should go to its bank to borrow now, they will be told that the prime rate is 10.5 percent. Banks are flush with money and anxious to make loans. The banker knows that the XYZ corporation probably could borrow in the commercial paper market at a rate something under prime. So he may offer the loan at 10 percent.
If the situation dictates, the banker may require that a 15 percent compensating balance be left in the customer's bank account. So in effect, the customer only has the use of 85 percent of the loan. This raises the cost of the loan to 11.76 percent. Or certain service charges may be levied against the customer which would also raise the cost of the money.
From the banker's side, he must consider the cost of the money to the bank; the amount of reserves that must be kept against the deposits; overhead; competition, plus the credit worthiness of the borrower. With those facts in mind, the banker will charge a spread over his costs, say 75 basis points. The bottom line is, that the prime rate may never be as it seems for various customers.
The Treasury will auction two-year notes on Wednesday. They will come in minimum denominations of $5,000. and should return 10.80 percent.