Money Management - January 2002

IT’s BAACK!

The Return Of Interest Rate Volatility

by Ted Schlazer

On October 31, 2001 the U.S. Treasury announced it will no longer auction a 30-year treasury bond. This will have a major impact on many markets, as this security is considered the benchmark by which all long-term rates are measured. For example, 30- year mortgage rates are benchmarked off the 30-year treasury bond. With this security being eliminated, the mortgage market will have to look for a different benchmark to base its rates. The most likely security will be the 10-year treasury note. It is interesting to note that the United States is the only country that currently issues a 30-year bond, although municipalities, corporations and government agencies will continue to issue 30-year debt.

The immediate impact of the announcement was a huge jump in the price of the current 30-year treasury bond, which went from trading at 102 ½ prior to the announcement to a high of 111 ¾ one day later. In an amazing reversal, just three weeks later this same bond traded at 99 ½ at one point during the day. We have not seen volatility like this since the early 1980s when interest rates were in the ’teens. The reason for the jump in price was readily apparent - supply and demand. Insurance companies as well as other financial firms are big buyers of 30-year bonds, which give them a guaranteed flow of income. Investors raced in to buy what was now going to become an extinct security. However, the reason for the subsequent decline was not so apparent.

After months of pessimism caused by a declining economy, terrorist attacks, dwindling consumer confidence, a plunging stock market and corporate layoffs, investors saw what they thought was a light at the end of the tunnel. Zero-financing plans caused auto sales to jump to record levels, as consumers rushed in to purchase automobiles. This contributed to a record spurt in retail sales, although the bulk of it was new auto sales. First time jobless claims fell for the fourth consecutive week in November and consumer sentiment spiked up. This was encouraging, since consumer spending accounts for two-thirds of the U.S. economy. In addition, the war in Afghanistan appeared to be nearing an end, further adding to consumer confidence. Markets, being more emotional than rational in the short-term, viewed this as a reason to sell bonds, as investors anticipated an end to the recession and an end to the Fed cutting interest rates. This caused bond prices and short-term interest rates to move violently. The two-year treasury note had its biggest one-week increase in interest rates in 20 years and the 30-year bond plunged almost 12 points. Whether this rosy scenario in fact comes true, only time will tell. Hopefully the light at the end of the tunnel won’t turn out to be a train.

Ted Schlazer
Ted Schlazer is first vice president and managing director for Mellon's Private Wealth Management group in Southern Nevada.