The Treasury bond market continued in a very unsettled fashion for most of last week. It seems that any unfavorable news that could hurt the market did just that, until Friday, when a strong rally occurred. Fed Chairman Paul A. Volcker's continued testimony before Congress touched a raw nerve once more when he mentioned that, given a certain set of circumstances, the dollar could plunge in the foreign exchange market. All of these uncertainties were being mirrored in the marketplace by caution on the part of many, and a withdrawal to the sidelines by retail buyers.
This wariness has begun to further reveal itself in the yield curves present in the short-term area of the market. Take, for example, the yield curve that can be constructed in the T-bill sector. Using a certificate of deposit yield equivalency for the discounted yields found on T bills, a yield curve for any particular time can be graphed from one-month out to 12 months. On that basis, on Jan. 25, the spread between the one-month T bill and the 12-month T bill was 133 basis points (8.85 percent vs. 7.52 percent). There are 100 basis points in a percentage point. Recently, that spread had widened to 219 basis points (9.94 percent vs. 7.75 percent). The reason is that as investors become more uncertain, they either stay in very short-term maturities or they sell longer coupon maturities and buy short T bills.
The same thing is happening in the certificate of deposit market except for one twist. On Jan. 25, the yield spread between the 1-month certificate of deposit and the six-month CD was 40 basis points (8.40 percent vs. 8.00 percent). Currently, the spread has widened to 125 basis points (10.10 percent vs. 8.85 percent). The twist is that banks, in anticipation of higher interest rates, are beginning to write more and longer-term CDs, thereby extending their liabilities. So supply becomes a factor in the longer maturities.
As the government market has floundered, we have had a respite from supply, but supply will soon become a serious problem for the government market. Another problem for dealers is that they have not been able to distribute all of the four issues they underwrote a few weeks ago. Therefore, with retail buyers on vacation and an avalanche of financing creeping up on the market, dealers are worried. Consider the following: on March 20, a $9 billion, 2-year note will be auctioned; the following week, three issues -- a 4 year, a 7 year and a 20 year, totaling $16 billion (of which about $12 billion will be new money) -- will sell. In early May, a quarterly refunding of three issues totaling a staggering $22 billion or so will be auctioned. No wonder retail had stepped aside, especially when you also consider the growing money supply and credit demands. This all helps to explain why purchasers of Treasuries are concentrating in the T-bill sector.
Another point that has become apparent is that since Volcker announced a few weeks ago that the Fed had terminated its ease program, interest rates have risen and, in effect, the Fed has tightened credit without any real activity on its part. The marketplace has done the tightening for the Fed. This is "open-mouth" policy -- with results -- at its best!