FINANCIAL MARKETS : Credit : Fed Steps In to Quell Fears of Increase in the Discount Rate

Treasury bond prices bounced up and down violently Thursday, but finished only moderately lower after the Federal Reserve quelled fears of a discount rate increase, traders said.

The central bank staunched a 1 21/32 point plunge in bond prices Thursday morning by aggressively adding temporary reserves via overnight system repurchases. The move laid to rest speculation that the discount rate might be raised Thursday.

The Treasury’s bellwether 30-year issue, which plunged 2 point, or $22.50 for every $1,000 in face value on Wednesday, finished down another 15/32 point, or about $5. Its yield, which moves inversely to its price, rose to 10.22% from 10.16% late Wednesday.

System Repurchases

On Thursday morning, an absence of confidence in the market sent prices into a free fall as traders continued to liquidate positions as a sequel to Wednesday’s decline. The market was levelled Wednesday by a less-than-glowing improvement in the U.S. trade deficit in August.

The Fed arrested the plunge in the market by offering system repurchases an hour earlier than usual, which sparked a short-covering rally and brought in a small amount of retail buying, traders said.

“I’m still in my foxhole,” said John Sebastian, executive vice president and chief economist at the Clayton Brown & Associates securities firm in Chicago. “We’re still reeling from yesterday.”

Currency markets responded by sending the dollar sharply lower. Because the Reagan Administration has sought a cheaper dollar as a way of evening out the trade imbalance, traders concluded that more depreciation was likely for the U.S. currency.

But because cheaper dollars reduce the value of U.S. securities held by foreign investors, this meant bond prices would have to go lower--sending interest rates, in turn, higher--in order to keep them attractive to foreign buyers.

Sebastian said he believed that much of the buying came from “short-covering” done by traders, who, concluding that the plunge was nearing a bottom, bought bonds to replace others they had borrowed and sold earlier.

Market Due for Upswing

At the same time, he said, the higher interest rates are also attracting longer-term buying as well, especially “on the tax-free side.”

“People are saying: ‘What? Intermediate-term tax-free bonds at 8%? Longer-term at 9%? I’ll take it,’ ” he said.

The federal funds rate, the interest on overnight loans between banks, traded at 7.6875%, up from 7.50% late Wednesday.

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