Economic Outlook: the Bond Market

The M1 obsession.

| May/June 1984

Economics is, above all else, a puzzling study . . . as evidenced by the fact that men and women who number among the world's acknowledged "experts" in this subject can be counted on to hold contradictory positions at any given time. For that reason, it's good to go "back to basics" occasionally, and take a look at the forces that influence our economy. In that spirit, MOTHER EARTH NEWS is pleased to be able to present this excerpt from "The Cult of M1" by Jonathan Rowe, adapted with permission from The Washington Monthly (November, 1983). 

We can't understand the monetary dances of the last few years without going back to where we started: the network of banks and investment houses that buy and sell government—and to a lesser extent, corporate—bonds.

The bond market is not a place, like the stock exchange. Rather, it's a telephonic clique. At the hub are 40 or so firms, ranging from the biggest New York banks to those mysterious investment houses like Salomon Brothers which seem to produce Republican economic advisers the way Darien produces debs. Through a gentlemanly process that is more like a club initiation than the granting of a license, the Federal Reserve selects these firms as the exclusive conduits for the “Open Market Operations” by which it buys and sells government bonds and tries to control the amount of spending money in the economy. Buy or sell, there is generally a profit for the bond house; and since all bond trading averages $50 billion a day, the profits can be substantial.

Two points will help us understand the psyche of this strange market. First, bondholders regard inflation the way a movie-magazine heartthrob regards age: It's a wipeout. Bonds yield a fixed return, which inflation only diminishes. Hence, given a choice between growth, which can mean inflation, and stagnation, which (to a bondholder, at least) is less risky, the bondholder will generally choose the latter. Second, and equally important, bond traders make money, not by clipping coupons, but by making trades. They are thus inclined to seize upon news that will make other bondholders feel dissettled, and just about anything will do. Merely by worrying aloud—in a speech in South Africa, no less—about the possibility of strong economic activity (good is bad, remember?) dour bond oracle Henry Kaufman of Salomon Brothers can almost single-handedly send the market downward, as he did back in August. But when it comes to jitter potential, nobody holds a candle to Federal Reserve Board Chairman Paul Volcker. The biggest game in the bond market has been what they call there “playing the M's.”

Paul Volcker's conversion to monetarism may have been of dubious benefit to the country, but in the bond houses on Wall Street it was an utter boon. The weekly M1 figure became the key to the mysteries, and hence a source of continual worry, a 24-hour roulette wheel at which the action never stops. [EDITOR'S NOTE: Put simply, M1 refers to the “spending money” active in the economy.] Last August 19, for example, bond prices rose almost two points after the Fed disclosed what appeared to be a $500 million drop in M1. On July 27, the Fed had reported that M1 had grown by $1.2 billion, moving banks to raise the prime rate by half a percent.

It used to be that the stock and bond markets were like the opposite ends of a seesaw, but now the stock dealers are worrying as much about the money numbers as are their counterparts in bonds. The M1 fetish is so intense that it has given rise to what Albert Sommers, chief economist of the Conference Board, calls a “cottage industry” of consultants, who provide the Wall Street equivalent of tip sheets on the Fed's forthcoming M1 figure. The tipsters aren't always awfully accurate. But, hey, if it gets people stirred up, it has to be worth something, right?

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