During the past few weeks, we seem to have gone through a Dr. Jekyll and Mr. Hyde type of market: a couple of good days followed by a couple of bad days. At any rate, the bond market of late has become very volatile. And none of this is surprising. Once a market has had a good price advance based on certain expectations, those expectations have to be borne out for the market to hold its gains.
The government market has just come through a $17.5 billion refunding in which government dealers underwrote a good deal of the issues. Because the issues had not been well distributed, the dealers were concerned about any uncertainties. Both the dealers and the buyers had felt that the Federal Reserve would continue to ease credit and that bond prices would move higher. The government market currently is being priced off of a yield spread against the overnight cost-of-money rate, the federal funds rate. Recently, the market priced itself off of a 9 percent funds rate. When the funds rate remained at 9 1/2 percent, something had to give. That something was the market, which sold off in an effort to realign itself with the higher funds rate.
Early in the week, stories appeared announcing that the rally had run its course. When the revelation was made that the federal budget deficit would be more than $200 billion, buyers retreated to the sidelines. But later, when weak economic numbers were released and the Fed supplied new reserves to the system, the market quickly reversed itself and moved rapidly higher. It is becoming more apparent that it will take lower rates to stimulate both the growth of the monetary aggregates and the economy. The market likes this conclusion and should continue to improve.
One sector of the market that has been unable to get out of its own way is the tax-exempt market. Supply, supply and more supply is the culprit. There is also the possibility that recent talk concerning a flat tax and tax reform, which could make tax exemption worthless, also is playing a role in limiting price advances on municipals.
On Wednesday, the Treasury will offer a two-year note in minimums of $5,000. It should return 10.65 percent.