Several weeks ago, we listed factors that we felt could influence the upward movement in interest rates. They were: The continuing growth in money supply; No meaningful action on the federal budget deficits; The possibility that oil prices might not decline as much as the market anticipated; The continuing strength of the dollar in the foreign exchange market (at that time), and; Doubtful passage of the Reagan administration tax reform program.
We could have added to this list of factors the heavy volume of new bond issues in all sectors of the market. The feeling was that a lot of bullish sentiment was already built into the bond market and should any of these events not come through, the bond market could be vulnerable to lower prices and higher rates.
Mixed and in some cases weaker economic numbers released in recent weeks helped the market improve. But continued growth in the money supply plus a political logjam on the budget and tax reform have caused a slight decline in bond prices and a small rise in bond interest rates. As a result, the questions can still be raised, which way interest rates, and what should one do with the proceeds from maturing high-couponed Treasuries?
One analyst looks at the "Catch-22" scenario we seem to be caught up in, that is, huge federal deficits, high interest rates, foreign demand for dollars to purchase U.S. financial assets, a strong dollar, cheap foreign imports, expensive U.S. exports and the resulting deteriorating manufacturing sector of the U.S. economy, and so forth. He concludes that the many imbalances in our economic and financial system will eventually lead to much lower interest rates.
In considering the possible solutions to the Catch-22 scenario, he considered the following solutions and their probable affect on interest rates.
First, the Fed continues an accommodative monetary policy -- then rates would remain stable or move lower.
Second, raise taxes to reduce budget deficits -- then consumer and business spending would more-than-likely slow, and the economy would continue to lose momentum, which would pull rates down.
Third, the Fed keeps rates down by "printing money," which the market, in time, would perceive as being inflationary -- then causing interest rates to move higher and eventually choking off an already weak economy, which would lead to a recession and lower rates.
Fourth, Congress votes a large deficit reduction package -- then interest rates would decline on the bullish news. Another underlying feeling in this scenario is that any jump in rates would "crush" the economy and lead to lower rates.
The bottom line for the Catch-22 scenario is that, even though interest rates may move higher on a cyclical basis (in concert with an improving economy), one way or another we seem to be marching on a path to lower interest rates.
The question arises, which path and when? For the bond buyer, this conclusion, if correct, has significant meaning. Although interest rates could go higher in the interim, it would eventually mean that double-digit interest rates on new issues would be history.
Consequently, bond buyers must decide two things. First, is the Catch-22 scenario really possible and, secondly, if so, how to take advantage of a world of falling interest rates?