The overnight coup that toppled Soviet leader Mikhail Gorbachev caused a sharp, brief spike in Treasury prices yesterday morning, as investors sought refuge from political upheaval in the safe haven of the U.S. government bond market.
The price gains faded quickly as the higher encouraged heavy retail selling and the stock market's restrained reaction discouraged traders.
By late in the afternoon, Treasury bills and short-term notes were slightly higher, and the 30-year bond was of 1/4 point to yield 8.10%. Early in the session, the long bond has been up more than 1 1/2 points, where it yielded 7.92%.
Although the initial flight-to-quality reaction subsided, analysts said the political upheaval in the Soviet Union would dominate Treasury trading this week.
If the situation there deteriorates, it would boost short-term prices, but economists said it was not clear how Soviet problems would affect the long end.
Long-term prices would suffer if Cold War tensions were renewed between the Soviets and the U.S. suggesting the need for more U.S. military spending and resulting in even higher budget deficits, or if a disruption of Soviet oil production increased inflationary pressures.
On the other hand, if the United States loses its export markets in the Soviet Union, that could add to the economy's problems, which would be a plus for the long end.
Short-term Treasury prices began to rise overnight in Tokyo after the Soviet news agency, Tass, announced that a state of emergency had been declared and that Soviet Vice President Gennady Yanayev had replaced Mr. Gorbachev for "health reasons."
A statement from the State Committee for the State of Emergency, which includes officials from the Soviet army and the KGB, said Mr. Gorbachev's reforms had entered "a blind alley" and "a mortal danger" was looming over Soviet Union.
While the short end improved in Tokyo, the 20-year bond initially sold off. But during the London morning session, the long end made a comeback as short-term prices continued to rally, and as New York traders came in, bond prices soared.
The buying of Treasury bills and short-term notes was a classic flight-to-quality reaction, traders said.
"Greed and panic rule this market, and you saw a good example of panic today," a note trader said.
But some questioned why long-term prices, already at high levels, rose as much as they did. Flight-to-quality buying usually occurs at the short end, which is more liquid and less risky than the long end.
In any case, the gains didn't last long.
Traders said they saw a lot of selling as dealers and retail investors took their profits from the earlier run-up.
"At 8%, investors will sell long bonds and buy something else," a note trader said.
And more selling occurred when U.S. stock prices stabilized in mid-morning, disappointing participants who had hoped the U.S. stock markets would be hit as badly as stock markets overseas.
The Nikkei index of Japanese stocks dropped 6% overnight, and the DAX index of German stocks fell 9.4%.
The Dow Jones Industrial Average was off more than 100 points during the morning, but came off its lows to hover 60 to 70 points below Friday's close for most of the day. It closed 69.99 points lower, at 2,898.03, which is only a 2.4% decline.
"The reason for which we got a big rally earlier was primarily the flight-to-quality syndrome -- the expectation that what happened to stocks in Tokyo and London would translate here," said Anthony Karydakis, a senior financial economist at First Chicago.
When the stock market stabilized, Treasury securities were not able to hold onto their earlier gains, he said.
A coupon trader said a lack of liquidity may have contributed to the early rally. The market's volatility was exacerbated by situation at Salomon Brothers, which caused some participants to worry about the amount of liquidity in the market, and by Hurricane Bob, which made some New York traders late to work, he said.
"It's a real spastic market," another note trader said. "There's very little liquidity and no conviction on top of that. Who knows what's going to come of this?"
Mr. Karydakis said the flight to quality could resume if the situation in the Soviet Union seems to be moving toward a civil war.
"Everything depends on the news we get from the Soviet Union over the next 48 hours," he said.
One consideration for the long end of the market is how the situation in the Soviet Union will affect U.S. military spending, Mr. Karydakis said. "If people assume military expenditures will have to be increased to face the new situation in the Soviet Union, you're talking about very gloomy prospects for the budget deficit."
The presence of military and KGB officials on the emergency committee seems ominous, but Kathleen Stephansen, a senior economist at Donaldson, Lufkin & Jenrette, questioned whether the committee would even try to return the Soviet Union to the kind of dictatorship that existed before Mr. Gorbachev's reforms.
For one thing, "the Soviet Union will need quite a bit of western capital," which suggests the hardliners will have to come to some kind of compromise, she said.
Some traders said the turmoil in the Soviet Union may be another factor encouraging Fed policymakers to ease again at today's Federal Open Market Committee meeting.
Joseph Plocek, an economist at McCarthy, Crisanti & Maffei, said yesterday's events give the Fed more room to ease, since the dollar surged against the mark and the short end is now expecting a move from the Fed.
Treasury Market Yields
Monday Week Month
3-Month Bill 5.22 5.44 5.71
6-Month Bill 5.40 5.60 5.99
1-Year Bill 5.48 5.76 6.24
2-Year Note 6.18 6.46 6.85
3-Year Note 6.60 6.84 7.28
4-Year Note 6.77 6.98 7.43
5-Year Note 7.30 7.46 7.90
7-Year Note 7.63 7.77 8.13
10-Year Note 7.82 7.94 8.27
20-Year Bond 8.07 8.19 8.41
30-Year Bond 8.10 8.21 8.46
Source: Cantor, Fitzgerald/Telerate
"If they really want to ensure that [the economy] pulls out of the recession in a timely way to prevent damage to things like real estate and insurance companies, why not pull the trigger when they can," Mr. Plocek said.
Other economists argued that the Fed will vote for a bias toward easing but wait to see more statistics.
"They will probably make a decision to stand ready to ease over the next couple of weeks, depending on the numbers they get," Mr. Karydakis said. "It could very well happen before the employment report, but they could well decide to wait until the see the employment report on Sept. 6."
The September bond future contract closed 5/32 lower at 97 11/32.
In the cash market, the 30-year 8 1/8% bond was 9.32 lower, at 100 2/32 - 100 6/32, to yield 8.10%.
The 7 7/8% 10-year note fell 1/16, to 100 6/32-100 10/32, to yield 7.82%.
The three-year 6 7/8% note was up 3/32, at 100 21/32-100 23/32, to yield 6.60%.
Rates on Treasury bills were lower, with the three-month bill down 14 basis points at 5.10%, the six-month bill off nine basis points at 5.20%, and the year bill 10 basis points lower at 5.21%. Salomon On Back Burner
Mr. Gorbachev's ouster pushed the Solomon Brothers scandal to the back burner yesterday.
"That [situation] and any numbers this week are just going to take second place," a London trader said.
Treasury traders are waiting for the regulatory fall-out, if any, from last week's revelation of illegal bids made by Salomon at Treasury auctions, but most said they do not expect Salomon's problems to affect day-to-day activity in the market.
On Sunday, the Treasury prohibited Salomon from bidding at auctions, then softened that prohibition after the firm's board of directors accepted the resignations of the firm's top three officials and named well-known investor Warren Buffet to manage the firm.
As it now stands now, Salomon may bid for its own account but not for customers.
Salomon was the biggest of the primary dealers, but traders said there are a number of other large firms eager to step in and take up any slack. The other firms in Salomon's league include Morgan Stanley, First Boston, Merrill Lynch and Lehamn Brothers.
But they do expect the revelation that Salomon entered illegal bids at Treasury auctions to result in tighter regulation.
"Certainly this sets the ground for more regulation," said Ms. Stephansen.
Also yesterday, Salomon Brothers said Eric R. Rosenfeld was named to run the firm's U.S. government bond operation "until a permanent head is appointed."
On Sunday, Salomon's board of directors fired the former manager of the government trading desk, Paul Mozer.
Mr. Rosenfeld, 38, is a managing director at the firm and most recently served as co-head of U.S. fixed-income arbitrage. He joined Salomon in 1984 after teaching at Harvard Business School and has a Ph.D. from the Massachusetts Institute of Technology.