Following the fixed income market certainly allows investors few dull moments. The explosive rally of the past two weeks has taken most by surprise. Few had anticipated a 5 point ($50 per $1,000 bond) price increase in the five-year Treasury note or a 10.75 ($107.50 per bond) point increase in the 30-year T-bond, in just five days. Most bond sectors participated in the advance, but "junk bonds" -- high yielding, high risk securities -- participated the least.
So where do we go from here? Perhaps the biggest problem now is to identify what forces will be driving the market. Think back over the past 18 to 20 months about what has driven the bond market. In the spring of 1986, interest rates declined in lock step with falling oil prices. Next we focused on the fate of the dollar in the foreign exchange market. As the dollar fell in value against the Japanese yen and other currencies, interest rates rose.
Then we became enamored with the rise in the Credit Research Bureau (CRB) Index, which told us that inflation had returned as a problem for the bond market. In the past two weeks, the market has begun to watch stock prices.
In actuality, the major influence on the bond market is the outlook for inflation and the activities of the Federal Reserve. Consequently, when the stock markets are getting bashed around the world, reason tells us that if it continues consumers will lose so much spending power that we will either become mired in slow economic growth or we will slide into a recession. Either event would lead to a lessening of inflation and would be positive for bonds.
If this scenario actually takes place, it will be incumbent upon the Fed to supply credit to the system in an effort to stave off an economic downturn. In effect, this means a concentrated effort by the Fed to lower interest rates, which is the stuff that bond market rallies are made of.
On the other hand, when the dollar moves lower in foreign exchange markets, it increases the possibility of higher inflation caused by higher priced imports and increases in domestic prices. This is why the falling dollar causes bond prices to decline and rates to rise. And there is also the need for higher rates to convince foreign investors to purchase U.S. debt.
There are so many facets to this complex situation that it is hard to tell on any given day which factor will influence the bond market the most. Regardless, it is the market's concern with inflation and with the actions of the Federal Reserve that basically influence the price movements of bonds.
However, three events would in time lead to a cure of our budget and trade deficits: First, a sizable reduction in the federal budget deficit by the politicians; second, an increase in interest rates, and, finally, a lower dollar in the foreign exchange market. The only problem with this solution is that it would lead to a recession-depression, which would be good for bonds.
The Treasury will offer a 3-year note in $5,000 minimums on Tuesday, a 10-year note in $1,000 minimums on Wednesday and a 30-year bond also in $1,000 minimums on Thursday. Although the market is quite volatile, they should return 8.0 percent, 8.9 percent and 9.1 percent, respectively.
James E. Lebherz has 28 years' experience in fixed-income investments.