Most market participants will admit to two facts right now: First, they are not really sure they know what's going on in the market, and second, they believe the Federal Reserve has eased its reserve restraint position in the banking system. The fact that the cost of overnight money, as measured by the federal funds rate, has declined from a daily high of close to 11.75 percent to 10.75 percent in just three weeks supports this belief.
However, the confusion and uncertainty arises from technical considerations within the banking system. During most of September, the Federal Reserve always supplies a large amount of reserves to the banking system. With the economy moderating, the banks' demand for funds slowing and the Fed supplying a large amount of reserves, the key federal funds rate could have fallen and carried with it the rest of the short-term rates.
In fact, since August, corporate borrowers have shifted their borrowings from large commercial banks to the less-expensive commercial paper market. The decline in short-term rates, and therefore in the cost of lendable funds to the banks last week, prompted several large banks to cut their prime lending rate by a quarter or half a percentage point.
More than likely, the Fed has eased for obvious reasons: The economy is moderating, high interest rates are making the dollar too strong, inflation is low and the monetary aggregates are well within their targets. Question: How much has the Fed eased, and for how long?
Last week we suggested that investors begin their tax swapping now and not wait until December, when chaos will prevail. To reiterate the new tax law regarding market discounts, tax-exempt securities are disallowed from taxing market discount as ordinary income, and secondly, the tax will only apply to taxable bonds issued after July 18, 1984.
To assist investors in improving the quality of their portfolios through tax swapping, we turned to Merrill Lynch's municipal research for suggestions on the quality of various state general obligation issues. Merrill's "quality trends" reflect the trend in the margin of interest and principal protection provided by an issue. If the trend of an issue is declining, it is a possible sell candidate. If the trend is improving, it is a possible buy.
The quality trends of the following state general obligations are considered declining: Illinois, Mississippi, Nevada, North Dakota, Oregon, Pennsylvania and West Virginia. State issues whose quality trends are considered to be improving are California, Delaware, Georgia and Massachusetts. Merrill considers the quality trends of the rest of the state issues stable, regardless of their credit ratings.