WASHINGTON - Any bond traders who put out sell orders last week because of James Baker's comments about lower tax rates are welcome to come to the nation's capital and take some respite at St. Elizabeth's Hospital, a mental institution. There they could quietly reassess market conditions away from the frantic trading room floors and the constant news flashes from the financial wires.
Mr. Baker, who is resigning as secretary of state to become President Bush's chief of staff and top campaign strategist, made a set of pro forma GOP comments for public consumption. Bond traders, struggling to digest the Treasury's $36 billion auction of notes and bonds, seized on Mr. Baker's tax-cutting remarks as an excuse to take profits.
Somehow it is hard to imagine traders sold off on genuine worries about a rising federal budget deficit in 1993 under a second Bush term.
After all, the big bond rally that has been unfolding since April, and the longer downturn in interest rates over the last year, have taken place against a backdrop of a rising federal budget deficit.
The latest forecast from the Congressional Budget Office calls for another record shortfall this year of $314 billion, up from last year's whopper of $269 billion.
The fact is that while government borrowing is on the rise, private demand for credit is languishing in a recovery that remains feeble by historical standards. There simply has been no crowding out" of credit demand by households and businesses, which is why bonds have done so well.
While the stop-go economy of the last three years has increased the rate of federal borrowing, "it has reduced the rate of borrowing growth in other sectors to such an extent that overall borrowing growth has fallen," according to an August article in Insight published by the forecasting firm A. Gary Schilling & Co.
"This happens in all recessions, but has been all the more pronounced this time around - and continues to last well into the supposed recovery - because of the unprecedented over-indebtedness of the U.S. economy as it entered recession. As the growth of demand for funds has fallen, interest rates have declined - and are likely to continue to do so."
Research by the firm, using Federal Reserve data, shows that while federal demand for credit rose 12.2% in the first year of the recovery, up from the historical average of 9.9%, growth in credit in other sectors is much slower or down. State and local borrowing is up 2.8%, compared to the historical average of 9.9%; household borrowing is up 4.2%, compared to 10.4%; and nonfinancial business borrowing is down 0.4%, compared to 8%.
Moreover, it helps to keep in mind that federal debt accounts for only 25% of total domestic nonfinancial debt. State and local debt makes up 8%, households, 36%, and businesses, the remaining 31%.
Analysts also point out that despite the drop in bond yields, the spread between nominal yields and inflation remains high by historical standards. The 30-year bonds auctioned last week by Treasury brought coupons of 7 1/4% and a yield of 7.29%, still lofty on a year-over-year inflation rate of 3%.
"I don't think 7% is meaningful stopping point for bonds. Six percent is a stopping point for bonds, although I'm not saying it will happen right away," said Neal Soss, chief economist for First Boston Corp.
Mr. Soss is among a small but growing number of Wall Street analysts who are emphasizing that the recovery, and inflation, will remain subdued for a long time. They say credit demand from the private sector will not pick up quickly, as it usually does in a recovery, because businesses and individuals are working off the huge binge of the 1980s and are not going to go back to their old spending ways.
But Wall Street does not want to send out a gloomy message about how the economy will be underperforming for the foreseeable future. That kind of view is terrible for brokerage firms trying to sell corporate bonds, mortgage-backed securities (now getting killed by the avalanche of refinancings), and stocks. The analysts are under pressure to hype their forecasts so that brokers and underwriters can sell.
The reality of sluggish demand for credit and a host of signs from the real side of the economy - slumping car sales, lackluster retail activity, weak personal income, and a slow manufacturing sector - all underscore the fundamental soundness of the bond market. Look for the bull market to keep on roaring.