The following editorial was published in Price Perceptions issue #995 on February 5, 1993

All News is Good News for Bonds

The Treasury sharply reduced the issuance of long term bonds in this week’s auction. Only $9.25 billion of 30 year bonds were offered, down $1 billion from the previous quarterly auction. They have also announced a reduction of $500 million in new 10 year notes to be sold next week. The cut back in long term offerings is designed to force long term interest rates down.

The yield curve (difference between long and short term rates) reached record levels last year. This allowed banks to pay low rates for short term deposits (about three percent) and invest the proceeds in long term Government bonds (about seven percent). When banks buy Government bonds, no reserve is required because Treasury securities are considered riskless. These factors made Treasury bonds a very attractive investment for banks.

In recent years, bank ownership of Treasury securities exploded due to…

  • Returns were nearly equal to business and individual loans.

  • Credit investigation is not required, costs were cut.

  • Bank examiners do not question loans made to the Government.

  • Bank capital is not tied up in reserves.
The Fed has been blamed for failure to expand money supply. However, bank loan expansion is the key to money supply expansion. When banks loan freely, money supply expands rapidly. When banks refuse to make loans, money supply grows slowly, or even contracts. Because long term Government bonds are a better investment for banks than loans to business and individuals, money expansion has fallen sharply below Fed expectations. However, if long term bond yields can be driven down closer to T-bill rates, banks will once again have a financial incentive to expand their loan portfolio. We believe this may be the primary motivation behind the Treasury's decision to limit new long term debt issues.

The following factors are expected to drive bonds higher over coming months…
  • Inflation is low and nearly all economists are in agreement that it will remain low for the foreseeable future.

  • The new Administration appears to be serious in their efforts to reduce the deficit. If higher taxes and spending cuts materialize, it will be viewed as very bullish on the bond market.

  • Nearly all industrialized nations are rapidly cutting interest rates. This makes U.S. bonds more attractive to foreign investors.

  • The Treasury already reduced 30 year bond issuance from an average of $12 billion in 1991 to $10 billion last year. The latest reduction to $9.25 billion is only another step in the same direction. It appears that additional cuts will be made in the future.

  • By shifting debt toward short term maturities, the Treasury saves money on interest expense. This also contributes to deficit reduction.

  • Lower long term rates are extremely popular with business and the public. They promote higher stock values, stimulate home building, and will eventually ease the money supply crunch.
It is difficult to make a short term case for lower bonds. Until short term interest rates increase materially, or money becomes easy enough to spur inflation, the historic bull market should remain intact.

Bill Gary
CIS, Inc.


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