The story of interest rates in 1987 unfolded on two fronts -- one international, the other domestic.
An international economist or investor will claim that the international sentiment toward currencies, trade and the economic outlook in the United States, as seen through the eyes of investors in Frankfurt, Tokyo and London, was the principal determinant of interest rates in 1987.
Our heavy dependence on capital from foreign investors to finance both the federal budget deficit and the current account deficit (of which the trade deficit is the largest component) were the underlying factors.
The international investor considers opportunity costs in evaluating investment prospects in terms of the premium on U.S. rates over domestic rates. Consequently, faced with larger investment risks in dollar-denominated securities, foreign investors demanded larger-than-usual yields to entice them into owning U.S. bonds.
In the United States, the main problems were what to do about the dollar -- whether to defend it or allow it to move lower in hopes of reversing the trade deficit -- and how to attract foreign capital in order to finance the trade and budget deficits.
Initially, the Treasury's dollar policy was anchored in the Louvre Accord, in which the Group of Seven industrialized nations -- the United States, Japan, West Germany, Britain, France, Canada and Italy -- agreed to support the dollar while the United States made efforts to reduce the budget deficit.
The dollar was actually stable from May to October, but the U.S. bond market was ravaged in the process.
Paul A. Volcker, then chairman of the Federal Reserve Board, decided in April that the dollar had fallen far enough, and the Fed began to tighten credit. As rates rose, the bond dealers, who had sizable positions going into the May financings, suffered devastating financial losses as bond prices plummeted and yields rose 1.50 percent.
The dollar improved and remained stable through the summer. However, the economy had begun to improve and the new Fed chairman, Alan Greenspan, raised the discount rate in early September.
Rates continued to rise until Oct. 19, when the stock market debacle forced the Fed to pump liquidity into the system to avoid any financial disasters. That action, plus a flight to Treasuries from stocks and a spectacular rally by dealers anxious to cover their sales commitments, all led to an nine-point rally in long Treasuries in just three days. Yields fell more than 1 percent during that brief period.
From the point of financing the federal budget deficit, two facts were important.
First, the main support for the Treasury market in recent years has been the private Japanese investor. But the continuing unstable dollar caused that investor to walk away from the Treasury market in the spring and to switch into the roaring U.S. stock market.
Second, the foreign support of the Treasury market shifted to the public investors (the central banks) of the G-7 nations and other major U.S. trading partners.
These central banks -- which had been supporting the dollar -- used their newly acquired dollars to purchase in the neighborhood of $45 billion in Treasuries and, in effect, financed one-third of our federal deficit.
In the money markets, the most significant factor affecting short-term rates and the short-term market was the huge paydown of Treasury bills by the Treasury.
During the first three quarters of 1987, the Treasury paid down or reduced the amount of T-bills outstanding by $49 billion.
This reduction in the supply of bills, the Treasury's inability to finance in June, and the flight to quality after the Oct. 19 collapse, kept short-term rates low and helped to maintain a very positive Treasury yield curve throughout most of the year.
In the government and agency market, the debt management authorities were in a comfortable position all year, since the foreign central banks were financing most of our budget deficit and there was a lower deficit to finance ($148 billion in fiscal 1987).
In fact, they overfinanced, having received greater tax revenues than expected along with unanticipated large sales of nonmarketable debt.
The Treasury had gross financings in calendar 1987 of $1.2 trillion, from which it raised $103 billion in net new money. By the end of the fiscal year, the total outstanding debt was $2.35 trillion, of which $1.68 trillion was marketable debt.
The volume of new corporate bond issues in 1987 was $119 billion, the second-largest year on record and 22 percent below 1986. Of that amount, low-grade or junk bonds were 24 percent of the total.
About $230 billion in mortgage backed pass-through securities were also issued.
Due to the dollar's continuing decline, investors looked for plays in other currencies. Investment bankers took advantage of this opportunity to introduce various types of securities linked to foreign currencies in an effort to allow investors to bet for or against the dollar.
This past year also witnessed continued credit upgradings of industrial companies, following five years of good economic growth. However, utility companies still suffered credit downgradings due mainly to cost overruns on unfinished nuclear plants by such as Commonwealth Edision and Georgia Power. It was a watershed year in the municipal bond market, a transition period in which we moved from the bullish psychology of the past five years to a more bearish position in which the participants refocused on the economic realities in the market.
From 1981, when bond prices were at their post-World War II lows, until March of 1987, when the bond rally came to an end, municipal bond prices rose 65 percent.
From March 5 until Oct. 16, long muni bond prices fell 21 percent. Volatility had returned to the market.
One dominant factor was the effect that the Tax Reform Act of 1986 had on the muni market.
The new issue volume was curtailed to $93 billion because of all the restrictions placed on the various tax-free issuers.
Placing this in perspective, the new issue volume in 1981 was $46 billion, and during the next five years -- 1982 to 1986 -- there was an explosion of new issues, with the volume peaking at $206 billion in 1985.
Obviously, this was an abnormal five years and the market is now returning to a more normal trend.
Further evidence of this is the change in revenue bond issuance as a percentage of the total issuance.
The issuance is moving back to the normal 50 percent to 60 percent that occurred from the mid-1970s to 1982, from the abnormal 73 percent that occurred in 1985.
Coinciding with this was the retrenchment from the muni market by major dealers like Salomon Brothers, Kidder Peabody, L.F. Rothschild and many more.
They had simply geared their underwriting and sales efforts to deal with the anticipated $200 billion years, which the new tax law brought to an abrupt halt.
Now most dealers are downsizing their operations for the lower volume of business expected over the next few years. The declining dollar played a dominant role in both the foreign exchange market and the international bond market.
The dollar, whose descent began in March of 1985, fell 24 percent against the Japanese yen and 18 percent against the German mark in 1987.
The main reason for this continuous downward movement was the eventual breakdown of the Louvre Accord reached earlier in the year.
The international community simply became disenchanted with the United States' efforts to take meaningful action in the reduction of the federal budget deficit, while they supported the dollar to the tune of more than $100 billion.
The dollar's downward spiral spilled over into the international bond market, affecting the issuance of dollar-denominated bonds in the Euromarket.
As a result of this nondollar preference, 86 percent ($99 billion) of the new bonds issued (a total of $115 billion) in the Euromarket were issued in nondollar currencies.
Also noteworthy was the continued rapid growth in international mutual funds denominated in foreign currencies.
They grew from $5 billion in 1984 to $24.4 billion in September 1987 before falling to $18 billion in October 1987.
Following the plunge there was a big shift from the stock to the fixed-income funds.
The Euromarket received an additional jolt when the U.S. Treasury threatened to impose a withholding tax on all bonds that had been issued prior to 1985 through dummy corporations in the Netherland Antilles.
This would have affected $15 billion in bonds, which the issuers would have had to call in, before the Treasury rescinded their ill-conceived tax proposal.
The crosscurrents in 1988 appear to be many and treacherous.
An election year, the sixth year of a record-breaking expansion, a dollar that is expected to lose more of its value, and expectations of increasing inflation should all combine to make for an interesting year.
James E. Lebherz has 29 years' experience in fixed-income investments.