Banks' investment in Treasury securities is leveling off, removing a major source of support enjoyed by the bond market over the past several years.

Loan demand has picked up this year and, in moving to meet it, banks have been far less enthusiastic buyers of government securities.

The banks' shift is probably a key reason why bond prices reacted as negatively as they did to the Federal Reserve Board's recent rate-tightening moves.

"Banks were the biggest buyers of government securities last year, but as things stand right now that is not going to be true again this year," said Sung Won Sohn, the senior economist at Norwest Corp., Minneapolis.

Hurting Bond' Market

"I think that is one of the main reasons why the bond market has been performing very poorly," he said Friday. "It's hard to create an exciting market

when the biggest player is pulling back."

What's more, Mr. Sohn thinks Fed policy, as well as the new loan demand, may be a factor.

"The Fed has been decreasing reserves in the banking system this year," he said. "In fact, they have been less and less accommodative in providing reserves since well back in 1993.

"It is not correct to say monetary policy was stable until the Fed first moved up rates [on Feb 4]," Mr. Sohn said. "They have been tightening down the reserve screws since last year.

"Had credit demand gone up in '93, we would have seen rising rates last year because of this," the economist said. "The Fed has actually been pursuing its anti-inflationary policy for some time now. If it continues to be stingy, the banks will have to curtail credit at some point

Bonds weakened and rates rose again on Friday after the Commerce Department said that the economy grew at a stronger rate of 3% during the first quarter than the originally estimated 2.6%.

The nation's banks held $754.9 billion of government securities as of May 11, according to Federal Reserve data. But bank purchases of securities have slowed by nearly half since their peak.

Over the past year, through April, banks bought $62 billion of government obligations, down from $122 billion in 1992, according to Edward Yardeni, the chief economist at C.J. Lawrence/Deutsche Bank Securities Corp., New York.

Fed's Rate 'Defensible'

Mr. Sohn of Norwest said he thinks the Fed's rate increases since February - primarily a 125 basis-point increase in its federal funds rate - are "defensible," but that further tightening might noticeably dampen the economy.

Mr. Yardeni has been strongly critical of the Fed. "I don't think the great patriotic war against inflation was necessary," he said recently.

"The enemy shows no signs of strengthening," he said. "Quite the opposite, inflation remains in retreat.

"There is greater risk that the Fed will accidentally shoot at our own forces," he said. "In other words, friendly fire could needlessly harm economic growth."

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.