Fears of higher oil prices and renewed inflation hammered the bond market yesterday as investors fled long-term issues until the Middle East picture is clarified and the Federal Reserve gives some indication of what its monetary policy will be.
Bond prices fell sharply in early trading yesterday when an expected signal by the Fed that it would ease credit failed to materialize. The slide then continued after White House spokesman Marlin Fitzwater called the Iraqi military buildup along the Saudi Arabian border a serious threat to that oil-producing country.
"I've been in the bond business a long time ... and I have never seen anything like what happened" in the first hours of trading yesterday, said Sherman Russ of Pioneering Management Corp., a Massachusetts-based money manager. Thirty-year Treasury bonds declined as much as three full points before recovering to close down 2 5/8 to yield 8.8 percent, Russ added. "It's very spooky."
The bond market situation raised serious questions for the Treasury Department, which is scheduled to sell more than $40 billion worth of bills, notes and bonds this week. A severely weakened market would boost the cost of government borrowing, putting further pressure on an already deteriorating budget situation.
"There are two countervailing forces at work in the bond market today," said Bruce D. Behling, president of the Strong Group of mutual funds in Milwaukee.
The first is fear of a weakening economy, "which should prompt further easing by the Federal Reserve," Behling said. This has allowed the short-term part of the bond market to hold up fairly well.
"The second force is the heightened inflation expectations" resulting from the Mideast situation, which is causing long-term bonds "to perform very poorly," Behling said. He added that in his view the outlook for the immediate future is "more of the same" until it becomes clear which force will prevail.
Against this backdrop, yields on 13- and 26-week Treasury bills issued yesterday dropped to the lowest levels in about two years. The new 13- and 26-week bills returned around 7.5 percent to investors, compared with the 8.8 percent yielded by 30-year bonds, traders said.
There was little doubt among these analysts that the Treasury's refunding this week will be more costly than it would have been only a few days ago. It is not clear how much interest foreign investors will have, particularly since current spreads between U.S. returns and those available in their home countries are much narrower than they have been in recent years.
"They all have the same concerns in their capital markets as we do -- rising rates, stock markets under pressure ... so there are concerns that they may not buy as much as usual," said Tim McKenna, manager of fixed-income trading at Fidelity Capital Markets.
However, Prescott Crocker, vice president of fixed-income management at the Colonial Group of mutual funds, said he believes foreigners will be "in aggressively" because U.S. returns have been good for them.
Several analysts said they believed that in view of the economy's weakening condition the Fed would allow interest rates to fall. But with the oil situation so uncertain, the central bank doesn't dare, these analysts said.
"I really think that if it were not for the crisis in the Mideast, long rates would be 8.25 instead of 8.8," said Charles Smith, president of T. Rowe Price's New Income Fund. "Absent this, the Fed would love to ease even more. But with inflation concerns what they are," they don't want a rerun of the 1970s where "they eased but it eventually led to quantum leaps in the inflation rate."