The bond market was buffeted by strong crosscurrents this past week and gave up ground in the process. One current that stirred the market was the failure of the congressional budget committee to agree on specific spending cuts. Although some cuts will eventually be obtained, a $225 billion deficit for fiscal year 1986 seems very real to the market, which resulted in lower bond prices.
The fact that bond prices moved lower in spite of a strong positive factor for the market was all the more significant. That good news was the revision of the second quarter gross national product number from being up 3.1 percent to being up only 1.7 percent. In other words, the economy is still weak, and by all sense of reasoning one would conclude that the Federal Reserve would continue with an accommodative monetary policy to nudge interest rates lower and, in the process, lower the value of the dollar in the foreign exchange market. All of this in hopes of stimulating the economy, especially the manufacturing sector.
Perhaps there is another factor coming into play that will have a big influence on interest rates. Lacy Hunt, the chief economist of Carroll McEntee and McGinley, states that international factors have been favorable to us over the last few years, but he feels that the tide is beginning to run out.
Hunt points out that from the low point of the dollar on the foreign exchange market in 1980 to its peak in early 1985, the dollar appreciated 40 to 50 percent. His studies indicate that each 10 percent rise in the dollar directly or indirectly lowered the U.S. inflation rate by 1.5 percent. Consequently, the 40-to-50-percent appreciation pared 7 to 8 percent off the inflation rate. Hunt believes that if inflation has been held down by the strong dollar and that if you reverse the foreign money inflows into the United States from the financial markets, you also divert the disinflation element in the process.
Therefore, Hunt asks, what else is there to check inflation? The monetary discipline is suspect with 13 percent growth in M1 during the second quarter, and Congress is unable to agree on budget cuts. Ergo, Hunt expects that eventually import prices will begin to rise as well as domestic prices and, hence, inflation and interest rates.
This scenario might jibe with the recent Japanese approach to our bond market. Most foreigners buy our bonds to enjoy the high real-interest rates and the benefits of the appreciating dollar. Now, with our short and intermediate interest rates having declined over 200 basis points and long-bonds down some 170 basis points, and with the dollar declining and the specter of rising inflation, it should come as no surprise that there has been little purchasing of U.S. bonds by the Japanese.
In fact, a trickle of selling has been noted. Could this be a straw in the wind of things to come? Until we see if rates are truly headed higher, investors would be wise to keep new funds in money market types of accounts or T-bills.
The Treasury will offer a two-year note on Wednesday in minimums of $5,000. They should return 8.85 percent.
For buyers of Maryland tax exempts, there is a $28 million Prince George's County issue that is "hunt up" or unsold in the market. This week, a $178 billion Washington Suburban Sanitary District issue will sell. With rates having backed up, chances are the Prince George's issue will have to be cheapened, especially in light of the large "Wash-tub" issue. Check 'em both for attractive yields.