With Congress having raised the debt ceiling to $1.825 trillion two weeks ago, the Treasury was free to embark on a massive $43 billion of coupon financing. This past week, a $5.5 billion seven-year note was auctioned at an average yield of 12.34 percent, and an $8.8 billion two-year note was auctioned at an average price of 11.73 percent. Aside from two weekly T-bill auctions and $8.25 billion of a one-year T-bill, five other coupon issues totaling $27 billion must be sold by Nov. 13.
The success of these auctions will be predicated on three factors, the first being the market's reception of the two issues that sold last week. The issues were well-received and eventually placed as prices rose. In contrast, if the seven- and two-year issues had been poorly received, the dealers would have been saddled with at least $10 billion in unsold notes and would not be aggressive bidders on the remaining issues.
The second important factor is investors' perception of Federal Reserve policy. Currently, investors feel that the Fed is easing reserve restrictions in the banking system, which will allow interest rates to fall. The federal funds rate, which measures the ease or restraint in the banking system, has declined by more than 150 basis points since the beginning of September.
Although this shows that the Fed has in fact eased, the big question is, how much has the Fed eased? Or, put another way, at what level does the Fed want the federal funds rate -- 10 percent, 10 1/2 percent or 11 percent? Because the market tends to get ahead of itself, it would be disastrous if investors felt that the new issues should be trading off of a 10 percent federal funds rate when in actuality the Fed was aiming for the 10 1/2 percent level. Investors would overbid for the new issues and would incur quick losses once it became apparent that the Fed wanted a higher federal funds rate. Consequently, correctly perceiving the Fed's intentions with a close eye on the federal funds rate is essential.
Lastly, the direction of the economy is extremely important now because it will not only help the Fed to decide on its course of action, but will influence short-term credit demands as well. The economy decelerated during the third quarter, and with it, short-term credit demands. With the decline of the federal funds rate, other short-term market rates followed suit. The less expensive cost of funds to banks, plus the competition of much lower short-term commercial paper rates -- 9.80 percent -- has helped to force down the prime rate to the 12 1/4 to 12 1/2 percent level.
However, short-term credit demands rebounded significantly during September, showing an increase of $11.9 billion. Should the demand for short-term credit continue through October, it would indicate that the economy was picking up steam again and would preclude any further easing by the Federal Reserve. Given this situation, short-term rates would reverse themselves quickly.
Consequently, the economic numbers being released for September in October, and for October in November, will play a significant part in the direction of interest rates on a near-term basis.
The Treasury will auction a 20-year bond on Tuesday, a four-year note on Wednesday and a one-year T-bill on Thursday. The coupon issues will be in minimums of $1,000, while the T-bill issue will come in $10,000 minimums. They should return 11.70 percent, 11.70 percent and 9.70 percent, respectively.