The bond market continues to be a difficult puzzle. For weeks analysts have felt that if something positive could be accomplished on the federal budget deficit, the bond market could be expected to turn in a better performance, or at least stop its decline. It was also believed that if the dollar stabilized at current levels, bond prices would improve.
Then the Gramm- Rudman-Hollings budget- balancing provision was "fixed" and, along with the debt ceiling extension, passed by Congress and signed into law by President Reagan. In addition, the dollar performed mightily against most other currencies in the foreign exchange market last week, especially against the Japanese yen and West German mark.
So guess what happened to the bond market? It got trashed, falling about 1 1/4 points in one day. Even the municipal bond market took it on the chin as tax-exempt rates moved higher.
When you sort through the ruins for answers, you are able to come up with several reasons for this behavior. For one, this is the end of the fiscal year in Japan and in an effort to get their books in order, Japanese currency traders covered their short positions, which in turn caused the dollar to rise. Japanese bond investors took advantage of the rising dollar to reduce their holdings of dollar-denominated securities, which in turn pushed the prices of U.S. Treasuries lower.
Concurrently, it was noted that interest rates around the world are rising as economies are improving and inflation is expected to increase in the coming months. In fact, forecasters are predicting that interest rates will be anywhere from 8.80 percent to 11 percent by year-end, with some analysts looking for a 12 percent rate by mid-1988. Predictions like that can give investors a lot of confidence in making investment decisions.
Through all of this foolishness several facts come through. First, the bond markets are reacting more quickly to adverse situations than ever before. To me, this means that investors have become a great deal smarter. Second, we are no longer an island, entire of ourselves. What goes on in Britain or Japan or the Persian Gulf affects markets in the United States and the rest of the world.
Third, the internationalization of the worlds' financial markets, with continuous trading somewhere every hour of every work day, has made the financial markets more volatile. Fourth, a major economic power is no longer able to bully the rest of the world in financial and economic matters. Eventually such a nation will have to conform to conventional or acceptable economic policies or face economic and financial chaos.
Finally, it is becoming more obvious that as politicians become more involved in our economic and financial system, the chances of a financial calamity increase, which is a tenet of the "Kondratieff Theory" or the "50-year cycle theory."
The Treasury will auction on Tuesday a 4 year note and on Wednesday a 7 year note. They should return 9.10 percent and 9.45 percent, respectively. James E. Lebherz has 28 years' experience in fixed-income investments.