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With economy soft and new rate cut in offing, markets perk up

By Staff writer of The Christian Science Monitor / June 30, 1986

New York

A gaggle of Wall Street gurus expected a boom to be upon us by now. The economic fireworks would begin in the second half of 1986, they said, with a period of robust sales, chugging factories, and escalating stock prices. With congressional elections coming up in November, it seemed a shoo-in.

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To stoke the tepid economy, interest rates were cut twice. Both the stock and bond markets responded with tremendous rallies. But by most indications, business has yet to respond.

Now, the consensus is building for another cut in the discount rate (the rate charged by the Federal Reserve for loans to financial institutions). And the financial markets are perking up.

The Dow Jones industrial average climbed 5.72 points last week, closing at 1,885.26 at the final bell on Friday. The bond market surged early in the week on news that Japan's economy contracted for the first time in 11 years. Many considered that an indication that rates here will tumble soon.

The rationale is that as pressure builds for central banks overseas to drop rates (West Germany's economy also looks limp), it eases Fed chairman Paul Volcker's concern that an interest rate cut here would push the United States dollar lower against foreign currencies.

Estimates now are that rates will be cut shortly after the Fed gets a look at unemployment figures on Thursday -- and if Japan cuts rates after its legislative elections (next Sunday). The Fed policymaking committee meets July 8 and 9.

``It's not just Fed policy now [that governs US interest rates]. It's global,'' says Steven Smith, fixed-income fund manager at Provident Capital Management in Philadelphia. ``You've got deflation worldwide. Look at what's left of the tin cartel, the oil cartel. Wage inflation [in the US] has disappeared.''

Mr. Smith says that he is ``extremely bullish'' on the bond market over the next three months. He expects lower interest rates. Although he doesn't expect much of a fall, he doesn't see any reason for rates to rise much, either. He guesses that Treasury bills will drop to about 5 percent and that long-term governments will land just under 7 percent.

Over the next year, rates on long-term bonds could bounce back by as much as 150 basis points (1 percent). ``But I'm not looking for double digits on long-term Treasuries. Not with Japan in a negative growth mode and the German economy so anemic.''

International influences on the financial markets show up in pricing, too. At present, 30-year Treasury bonds are relatively expensive (and yields relatively low) because of strong British and Japanese buying.

``The Treasury market has become a very crowded pool,'' says Daniel Grant, editor of the Grant Interest Rate Observer, a weekly publication.

``The Japanese insist on buying government bonds and staying away from corporate yields. That serves to depress government yields.''

Mr. Smith and Mr. Grant both note that this situation has made municipal bonds, mortgage-backed securities, and corporate bonds relatively cheap. Grant's advice to the long-term fixed-income investor: ``If you're of the conviction that rates are coming down, don't look at Treasuries.''

To support his advice, he points to an A-rated Ralston Purina 30-year corporate bond issued last week. ``It sold at a yield of roughly 9. The [30-year] Treasury yield is roughly 7.4 percent.''

Corporate bonds typically sell at higher yields, because investors believe there is more risk that a company could go bankrupt than that the federal government would ever default. Even so, says Grant, ``That spread between good-quality corporates and Treasuries is wider than in anyone's memory.''