From the beginning of the year, the directions of the Treasury and municipal markets have paralleled one another. The long T bond has declined about 109 basis points, while long municipals, as measured by the Bond Buyers Revenue Bond Index, has declined 106 basis points. There are 100 basis points in one percentage point.
However, since the first of July, the long T bond has given up 40 basis points while the R. B. Index has remained unchanged. There are several reasons why the municipal market has been outperforming the Treasury market during July, but the major consideration has to be the administration's proposed tax reform program. The fallout from this proposal is widespread.
First, the program would eliminate the "private-purpose" bonds from the new-issue calendar. Private-purpose bonds are issued by state and local entities, but their proceeds are made available for use by private businesses, certain tax-exempt organizations, homeowners and students. The tax program also would prohibit refunding outstanding issues with new issues bearing lower interest rates. Analysts feel that by combining the two categories,as much as 50 to 65 percent of a possible $100-billion-per-year new-issue calendar would be excluded. The new-issue supply would be reduced dramatically.
On top of this, commercial banks, through the proposed tax reform, are faced with the prospect of loosing their 80 percent tax deduction of interest expenses incurred in carrying municipal bonds. However, tax-exempts purchased in this manner before any tax reform legislation is passed would be grandfathered and allowed. This has led many banks to purchase maturities beyond their normal 10-year range, and to buy now before the legislation is passed.
Fire and casualty insurance companies for the past several years have been operating in the red. But recent insurance rate increases have begun to turn their loss situation around and to give them income to shelter. As a result, for the first time in many a moon, these companies have begun to purchase tax-exempts, and their needs should increase in 1986.
The Treasury market, on the other hand, is more sensitive to Federal Reserve operations, the direction of the dollar, the growth of the money supply and other forces that have been prominent in the financial news of late. Also, strong support for the Treasury market has come from abroad, especially from Japan. In recent weeks, the depreciating dollar has cooled foreign demand for treasuries. Should the dollar strengthen again, the demand situation could quickly reverse itself. Also, Federal Reserve Chairman Paul A. Volcker's remarks before Congress this month that there is no need for a further cut in the discount rate at this time disappointed the market. With the chairman's remarks in mind, and with a $21 billion Treasury refunding just two weeks away, Treasury buyers retreated to the sidelines.