The Federal Reserve Board has stated that it would like to slow down the recovery in an effort to dampen any recurrence of inflationary psychology as the economy improves and is accompanied by sizeable increases in the monetary aggregates.
Fed Chairman Paul A. Volcker has once again brought to the forefront the budget situation and the perils that could result if the deficits are not dealt with by Congress and the administration. Volcker underscored the specter of rising interest rates resulting from the clash of both federal and private borrowers.
It would appear that many of these worries and fears have coalesced to the point that the markets have responded with a dramatic reversal in interest rates as the table below indicates: YIELD CHANGES
See Chart in Original.
If the various yields were plotted for each of the two days, we would see the resulting yield curves have simply moved higher on the scale. Also, when the yield curve is measured by tracking the 3-month T bill against the 30-year T bond, we see that the curve has also steepened, going from +239 basis points in May to +273 basic points last week.
The question now becomes, how much farther must interest rates rise to accomplish what the Fed would like to see accomplished? It would follow that the interest-sensitive sectors like borrowing by consumers to purchase autos and home building would be the areas most affected. Builders feel that the 13 1/2-to-14 percent mortgage rate level is critical to the home-building and construction industries. Since we are at that level now, home-building can be expected to slow by the fall if interest rates edge higher.
Some economists feel that the economy has such a strong head of steam that it will take even higher rates to slow down the recovery locomotive. Yet other pundits feel that this rise in rates is an aberration that will correct itself by yearend.
One cause for the rise in rates could easily be laid at the doorstep of the heavy Treasury financing, which is a direct result of the budget deficits referred to by Volcker. In figuring the actual Treasury financings from April through July and estimating the needs for August and September, you arrive at a total financing of $507 billion for that period. That compares with a figure of $427 billion during the same period in 1982. Further, in 1982 we were at the trough of the recession with little credit demand from the private sector, while now, as the recovery picks up steam, we are just beginning to see an increase in the credit demands from the private sector. Certainly, the recently heavy Treasury needs have helped to push rates up.
With the dramatic change in government rates has come change in the yield relationships between municipals and Treasuries. According to data compiled by Municipal Market Data Inc. of Boston, munis are rich versus Treasuries. This new relationship has occurred for two reasons. First, in measuring the performance of the 30-year Treasury against a 30-year municipal index, you see that the Treasury bond has declined 15 percent since mid-May, while long municipals have fallen only 7 percent. In a word, the municipals outperformed the Treasuries during the decline.
The second reason for this change reverts back to the supply factor. The supply in tax-exempts is measured by combining the 30-day visible supply along with the total of the Blue List, the market's listing of dealers' inventory. This figure dropped from a high of $6.3 billion in May to a low of $3.8 billion last week. During the same period, the Treasury was a heavy borrower.
These changes in yield relationships mean that if interest rates stay at current levels, buyers of tax-exempts should hold cash and wait for the municipals to cheapen. If interest rates are to decline, then Treasuries will respond quicker. And if rates on Treasuries continue to rise, municipals will have to sell off more to adjust to the higher Treasury yields.