It appears that the fortunes of the bond market may be changing for the better, at least for the time being. Not only was the recent inflation report bullish for bonds, but much of the growth in the gross national product in the fourth quarter was caused by a buildup in inventories. Since this denotes a weaker economy, bond prices soared.
Other factors emanating from abroad also are positive for the market. In mid-1987, private Japanese investors stopped buying U.S. bonds and shifted their buying to U.S. stocks. This is probably one of the main reasons that bond prices began to fall, rates began to rise and stock prices continued to hit new daily highs -- until Black Monday.
However, a new buyer -- the Bank of Japan -- appeared on the scene. Flush with dollars it had acquired from supporting the dollar in the foreign exchange market, Japan's central bank bought Treasury bills. This helped the United States finance its budget deficit and also gave the Bank of Japan a return on its reserves.
At the end of the year, the Bank of Japan had $81 billion in foreign exchange reserves. Early this year, the bank perceived that the U.S. trade and budget deficits were not going to improve soon, and that the bank would have to indefinitely continue supporting the dollar, which had stabilized. So why not earn a higher interest rate by buying the longer-term U.S. T-notes and T-bonds? With the dollar stable -- and with the agreement of U.S. allies to continue to support it -- the foreign exchange risk would be minimal.
The purchase of the longer U.S. securities would continue to help the United States in financing its budget deficit and also help to push U.S. interest rates lower.
At the same time, West Germany -- whose economy grew only 1.7 percent in 1987, down from 2.5 percent in 1986 -- decided that its inflation was under control and embarked on an easier monetary policy to stimulate its economy. That will cause interest rates to move lower in West Germany, meaning that the United States can allow its rates to fall and still attract foreign funds to cover the trade deficit.
The Japanese, even with their strong economy and burgeoning money supply, also are taking steps to further lower their interest rates. This will allow the Japanese to raise the costs of their exports to compensate for the currency losses they have sustained because of the falling dollar. But even though this will hurt the export side of their economy, their lower domestic interest rates will help spur their domestic economy and offset the loss of trade.
All in all, it would appear that the foreigners have come to the realization that it will take the United States a long time to solve its financial problems. In an effort to protect themselves, they are undertaking policies that will not only benefit their economies, but will help to protect their investments in the United States.
These good tidings for the bond market could not have come at a better time for the Treasury, which last week announced a $27 billion quarterly refunding that will be sold this week.
A three-year note, in $5,000 minimums, will be auctioned Tuesday. The 10-year note, in $1,000 minimums, will be sold Wednesday, and the outstanding 29 1/4-year Treasury bond, also in $1,000 minimums, will be reopened and sold Thursday. These issues should return 7.40 percent, 8.20 percent and 8.40 percent, respectively.
James E. Lebherz has 28 years of experience in fixed-income securities.