The bond market continued to buckle under the weight of new issue supply, a stronger fourth-quarter GNP number than was expected, the continued growth in the money supply and, perhaps most damaging, the testimony of Chairman Paul A. Volcker of the Federal Reserve Board before the Senate Banking Committee. Prior to Volcker's appearance, some analysts had speculated that his testimony would be "good" for the bond markets, that the good news concerning inflation would be emphasized.
Government bond dealers still owned a good portion of the recent Treasury refunding and had to bid on the $9 billion, 2-year note on Wednesday. The overnight cost of money -- the federal funds rate -- was still bouncing around 8.50 percent, while the cost to dealers for carrying their inventory -- as measured by the "repo" rate -- was also creeping higher. These events in themselves were enough to make dealers nervous. But being greedy, and also in finding no buyers for their bonds since legitimate retail buyers sensed the dealers plight and had withdrawn from the marketplace -- the dealers were hoping for some good words from Volcker to bail them out of their precarious situation.
However, when the chairman stated that Fed's late 1984 easing had ended, dealers rushed to cut prices and reduce their inventory. Volcker also repeated his warnings concerning the budget-deficit, trade-deficit problem and the fact that, "we are in a real sense living on borrowed money and time." To say the least, this is not wht a nervous market wanted to hear and retail buyers remained on the sidelines in spite of the price cutting. The 2-year note auction was not well participated in on Wednesday and produced an average yield of 10.12 percent. By noon on Thursday, the 2-year note was being offered on a 10.30 percent basis. In fact, the three Treasury issues from the refunding were also well underwater by Thursday afternoon. More than likely the sell-off is overdone, and there will be some correction, but for the time being, we have seen the low yield levels that were reached in January.
The municipal market wilted from the stress of a declining Treasury market, a large supply of new high-grade general obligations, and from an increasing large amount of unsold bonds that are collecting on dealers' shelves. As a result, the new issues were not really well received and the dealers' unsold inventory, as measured in the Blue List, jumped up to $1.88 billion. This large amount of unsold bonds is harmful from two standpoints. First, the dealer's capital must be used to carry these positions, which in turn reduces their ability to commit capital to purchase new issues. Second, assuming that the unsold merchandise is being offered at a certain level, say 9.50 percent, the dealer must bid for new issues at a cheaper level, say 9.75 percent, in hopes of being able to sell the new bonds. This undermines even more the position of bonds being offered at 9.50 percent. Sooner or later, the dealer must cut his price on the stale merchandise and swallow his losses. That's the type of situation we seem to be in now, and yields on 10-year insured bonds are creeping up close to 9.00 percent again.
On Tuesday, the Treasury will offer a five-year, two-month note in minimums of $1,000. They should return 11.40 percent.