Bulls and Bears on Bonds

WILL ROGERS, in one of the last of his inimitable ‘colyums,’ once defined depression. ‘Depression,’ he said, ‘ain’t nothing but old man interest just gnawing away at us.’ In these homely words the fireside philosopher was unconsciously echoing the ratiocination of a new school of economists and monetary statesmen. Many tomes have been written which have said no more than America’s latter-day humorist said in his ungrammatical sentence. Whether because of the debtor experience underlying Will Rogers’s apothegm or because of the scholarly studies rationalizing it, government policy in regard to money has been recast. In both the United States and Great Britain that policy has been concerned with keeping money plentiful and cheap. A governor of the Federal Reserve Board recently said that the rate of interest would be depressed till there were no more people unemployed and no more productive resources unused. In Great Britain, J. M. Keynes, the academic leader of the cheap-money school, wrote in the London Times, on January 13: ‘We must avoid dear money as we would hell-lire.’

You will gather from these extreme statements that the rate of interest is very significant. It is significant. The rate of interest may be regarded as second in importance of all economic phenomena. Pride of place is occupied by the price level, the fulcrum upon which the lever of production rests. But, with the growth of capitalistic enterprise, most production is bound up in contracts; and the fulcrum of those contracts is the rate of interest. This is the means whereby those who have capital to lend are brought into relationship with those who want to use capital. As with all economic transactions, the relationship is facilitated when the rate is cheap.

The rate of interest is thus the price of capital. For many reasons there is no standard rate. But in practice the yield on the funded debt of the Federal Government is generally accepted as representative of it. The fluctuations of that yield over long periods, that is to say, are reflections of changes in the rate of interest. It follows that, if the long-term rate of interest is to be controlled, control must begin with the price of government bonds. If they are kept high, the yield on them remains low, and this enables the United States Government to borrow on cheap terms — and other borrowers, mutatis mutandis, likewise.

One of the phenomena of recent years has been the lowness of bond yields. At the December convention of the American Investment Bankers Association, Dr. Lionel D. Edie said: —

At the present time there is only one extreme bull market in this country, and that is in the bond market. That is a real bull market, and the measurement of it can be indicated by simply stating that new all-time highs have been made for practically every grade bond in the list, and that many classes of securities are selling on a money rate basis that is entirely without precedent in the history of this country, or in the history of Great Britain. This is a great bull market.

Just after Dr. Edie spoke banks, other financial institutions, and individuals competed for the privilege of buying new 17-year 2 1/2 per cent bonds offered for sale by the Treasury. In 1929 there would have been no offers; for in that year the average yield on government bonds was .50 per cent higher than the return offered by the Treasury last December. But so great was the anticipated scramble for the 2 1/2’s that Secretary Morgenthau had to ration ihe applicants.

This bull market in bonds continued well into the new year. The 21/2’s, for instance, have been traded in the market at a price of 101 22/32, or on a yield basis of 2.38 per cent. But in mid-March there was a dip in the bond market, a dip substantial enough to put the credit rating of the Federal Government up to 2 3/4 per cent, or a rise of one quarter of one per cent since December. The decline dragged other bonds along with it.

There was a galaxy of reasons for the dip. A few of them I append hereunder: —

1. Banks, which were the chief sellers, turning their governments into cash in preparation for May 1, when, under an order issued by the Federal Reserve Board, the legal requirements for their reserves against their deposit liabilities will be advanced. This advance will reduce their excess reserves to half a billion dollars, as compared with six times that amount a year ago; at a time, moreover, when commercial borrowing is rising fast.

2. Psychological selling. Seeing the banks at the head of the procession, private persons started to liquidate holdings on the old motto of getting out while the getting was good.

3. Selling animated by a conjuncture of circumstances as well as by example. Chief of these circumstances was the antecedent rise in commodity prices the world over. The index of speculative commodity prices compiled by the International Statistical Bureau, Inc., had shown a gain of no less than 39.2 per cent above the 1936 low. Prices in this index are futures and therefore reflect speculative tendencies to a greater extent than spot prices. Even Moody’s index of spot prices, however, was higher by 24 per cent, while the much broader index put out by the Bureau of Labor Statistics had recorded a gain of 6.2 per cent, with most of the increase in the recent months. All precedent agrees that the price of capital rises sympathetically with any such rise in commodity prices. Dr. E. W. Kemmerer has plotted the course of interest rates and commodity prices in Great Britain over a period of 155 years and in the United States over the past 85 years. His charts reveal that close correspondence has prevailed consistently between these two indexes.

4. Crack in the British market for British government securities several weeks before the break. From 2.90 per cent at the end of 1936, British government credit had declined to 3.30 per cent. In spite of the lack of any nexus between the two bond markets, such as was created by the old gold standard, the event in London caused the question to be asked in New York: ‘Is the long-bruited change in trend coming?’ When questioners are those who determine trading, they are apt to answer such a question by selling.

5. Inflation talk in Washington, which would logically drive persons out of bond holdings into inflation ‘hedges,’ such as real estate, stocks, or commodities.

6. Selling for the purpose of making incometax payments.

Such a conjuncture of circumstances explains the dip. But it does not tell us much about the future. Winthrop W. Aldrich, Chairman of the Board of the Chase National Bank, says that ‘prevailing low bank lending rates of interest are a function of excess bank reserves.’ The mopping up of excess reserves would therefore seem to foreshadow a lift in long-term money rates. However, in keeping down the long-term rate of interest, though not the short-term rale, it is immaterial whether the spare reserves are half a billion or five billion, so long as they are spare; the process involves no contraction in the current supply of credit money.

The question of the future of the long-term rate of interest is twofold. First, is the time, in the normal course of events, ripe for a continued rise? Secondly, if the answer is yes, can the authorities in Washington ‘buck the trend’ in carrying out a policy which Marriner S. Eccles, Chairman of the Federal Reserve Board, on March 16 reaffirmed in these words: ‘I cannot favor at this juncture the remedy of “tight money” and high interest rates to reach special conditions’?

As to the first question, the inquirer would naturally look into conditions in the capital market. Interest being the price of capital, it would naturally respond to the law of supply and demand, like every other price. The supply of capital would normally have risen considerably by this stage of recovery. However, it has been impeded by New Deal tax policies. These policies, particularly the tax on undistributed corporation surpluses, are destined precisely to impede capital formation. The theory is that heretofore there has been ‘over’ saving. So the new object of the ‘abhorred shears’ is not only to raise money; it is to redistribute incomes with the view of encouraging consumption at the expense of saving.

How about the demand for capital? Up till March this was growing fast. In 1936 it amounted to nearly three times the aggregate of 1933, though it was still only about a fifth of the 1929 total. In February of this year new capital financing reached $129,842,030, or nearly ten times the amount in February 1936, when the total was only $13,472,714. But for the break in the bond market in mid-March, which made many corporations pigeonhole new capital demands till they could see how much they would have to pay to satisfy them, the March total would have been even more impressive.

There is apt to be a swift impetus in the demand for any economic good when the corner has been turned. In the commodity markets, for instance, the reassertion of demand by world users of raw materials has been spectacular. In early March the same phenomenon looked as if it might be repeated in the demand for capital by the great industrial users of it. Particularly does the demand for capital become urgent when commodity prices are rising fast. As Dr. Kemmerer says, in explaining the historic correspondence between the rise in interest rates and the rise in the price level: ‘People want to get capital goods to-day because they are going to be dearer to-morrow, and a rising demand for capital (with a constant, declining or loss rapidly rising supply) pushes up interest rates.’

The demand for capital, moreover, is encouraged by one of the major reasons forcing up prices. This is the depreciation of world currencies. For the first time in a hundred years the standard of value in the United States has been depreciated by government edict. In addition, billions of credit dollars have been poured into the economic system in furtherance of‘reflation.’ ’Reflation’ has been described as inflation with one’s fingers crossed, and the strong rise in commodity prices is doubtless due in part to the easy money policies pursued on the basis of a depreciated monetary unit; it is, in short, inflationary. In this situation Dr. Kemmerer’s remark applies with even greater force.

Thus the time is ripe for a natural rise in interest rates. The second question — whether the rate of interest can be kept down artificially by governments in spite of all the natural forces urging it up — is now the football of the economists. The affirmative comes confidently from the cheap-money theorists. In fact, they adduce as the prime reason why government intervention can hold down the rate of interest one of the very reasons which we have already adduced for a rise. This is government enlargement of the credit base, or reflation.

The argument deserves more space than I can give it. I can only abbreviate it. Government credit has been used to eke out the deficiency of capital. With this help the rate of interest has been kept down since 1933 while the price level has been rising. So far, so good. But there is a limit imposed upon this process of ’reflation’ — a limit marked by the danger signal of inflation. And a plague attaches to inflation! Therefore, in response to this signal, the Federal Reserve Board decided to contract the credit base by locking up some of the banks’ excess reserves. No doubt the monetary authorities hoped that this could be accomplished without affecting the rate of interest in any material way. What, however, has happened is that the other factors in the world of capital have been allowed to come into play in putting up money rates.

The problem facing the Federal Reserve Board is, therefore, a dilemma. To put it at its baldest, it is to slave off an incipient boom by limiting credit money and yet to keep down money rates so as to make cheap and abundant credit the servant of continued productivity! With almost unanimous voice the classical economists say that it cannot be done. Banking leaders are divided pro and con. And the rank and file of bankers, in consequence, are just as full of bulls as of bears on bonds.

Already cons among both economists and bankers are saying that the mid-March dip in the bond market marks ‘the twilight of managed credit.’ However, money, though dearer, is still cheap, and during the March break Washington merely intervened to cushion the decline. Moreover, the monetary controllers see themselves only at the beginning of an experiment in which they are gathering experience. They will not drop it in a hurry. For their spur is the social gospel implicit in Will Rogers’s pithy comment. A whole pile of weapons still lie in the armories of the Federal Reserve Board and the Treasury with which to enable them to use police powers over the money market when at last they are confronted with the dilemma which we have posed as their ultimate problem.

It is difficult, nevertheless, to envisage successful pegging of the price of capital, as of any other price; and we may at least conclude that the bottom in the long-term rate of interest has been left behind.