Rate Cuts Aid Financing of Public Debt
In reviewing the U.S. Treasury bond market in 1991, one cannot help but be impressed by the steep decline in interest rates and by the volume of actual financing.</br></br>We are all aware of the weakness that permeated the economy and how the Federal Reserve responded to that weakness during the year. Initially, an economic rebound was anticipated, but when one failed to develop, the Fed responded with dramatic cuts in short-term ÛÏadministeredÛ ratesÛÓthe discount rate and the federal funds rateÛÓwhich the Fed directly controls.</br></br>As a result of these cuts, two-thirds or more of the decline in the short rates occurred in the second half of the year, with most of that decline occurring in November and December. Consequently, the yield curve, as measured from either short rates or from the two-year note out to the 30-year bond, widened to record levels. For example, the Treasury yield curve (two-year note to the 30-year bond) began the year at a spread of -1-102 basis points and closed at +266 basis points. At midyear, the curve was only +146 and by December had widened to a high of +276 basis points.</br></br>However, since the deficit continues to grow, the overall interest cost of the debt continued to rise. To be more correct on this point, if interest rates had not declined so much, and the curve had not taken on such a positive shape, the interest cost for financing the debt would have been probably as much as one-third higher.</br></br>Another feature of last yearÛªs market was its ability to finance such a huge amount of debt at such modest interest rates. True, the anemic economy and the Fed helped a great deal, but when one considers the volume of financing, it is quite incredible.