The decline in interest rates which began in mid-March has been driven by several factors.
They are: a weak economy, low inflation, the anticipated sizeable cuts on the spending side of the federal budget, the expected decline in oil prices, the need to have a lower dollar on the foreign exchange market to correct the trade deficit, the anticipated tax reform program and finally -- for all these reasons -- the ability of the Federal Reserve to be able to ease monetary conditions, which helped interest rates to decline.
All of these factors relate to fundamentals that have for the moment given direction to the bond market. But how reliable are these factors now and is the bond market vulnerable if several of these factors deteriorate? A view of these premises could prove useful.
Money supply has been growing since October, and history has shown that in time, with continuous growth in the monetary aggregate M1, the economy will begin to grow and so will inflation.
Congress has based budget deficit action on these assumptions:
* Real Gross National Product growth through 1988 will be 4 percent;
* The rate of inflation will remain stable;
* Interest rates will continue to fall.
In light of the weak economy during the first half of 1985, analysts now estimate that real GNP will probably be 2.0-2.5 percent for the entire year. This means less revenue to the government and a larger deficit. This week, David A. Stockman of the Office of Management and Budget estimated that even if the entire budget reduction program before Congress is passed as presented, the deficit could be $70 billion larger than projected for 1988 because of the faulty assumptions being used by Congress.
Some oil analysts feel that the price of oil could fall to $20 a barrel by year's end. However, other oil analysts disagree with this assessment and feel that oil prices will stablilize and in time move higher.
They point out that the price of oil is closely related to production and that the Organization of Petroleum Exporting Countries' (OPEC) Mideast members, who control 67 percent of the world known oil reserves, would rather control or limit production than lower prices.
Lower prices means lower revenues, which would lead to greater oil production in an effort to keep revenue, which in turn would force prices even lower.
Further, if prices decline, there will be less oil exploration for a finite commodity. Consequently, it is in everyone's best interest to keep prices where they are until demand pushes them higher.
And in spite of the approximately 220 basis-point decline in short-term rates and 180 basis-point decline in long-term interest rates since March, the dollar has remained strong. In fact, from the first of the year, the dollar is up 10 percent, while from its peak in February, the dollar is down only 12 percent on a trade weighted basis.
Lastly, even though the tax reform legislation is being perceived as bullish for bonds, not only is its final form uncertain but so is its time of passage. Some analysts doubt that it will be passed before the 1986 national elections.
The bottom line then is, even though certain administered interest rates like the discount rate or the prime rate could still be lowered, one seriously has to wonder if the factors supporting the move to lower interest rates have lost their impact or could be deteriorating.
To put the problem another way, given the facts mentioned, and assuming the economy is definitely not in a recession, it would appear most unlikely that the next move in interest rates would be to lower levels.
Perhaps the time for profit-taking and defensive measures are at hand. At any rate, lengthy extensions of maturities could prove unwise until the picture is clarified.
The Treasury will offer two year notes on Wednesday in minimums of $5,000. They should return 8.45 percent.