U.S. Treasury Markets
Nowhere was the impact of the new regime, particularly monetary policy, more obvious than in the U.S. treasury markets. After a decade in which monetary policy appeared subservient to political goals, it became the principal government policy lever to control inflation, and the actions of the Federal Reserve were so aggressive in this respect that they overrode many of the other influences on interest rates. The academic literature gives little attention to the institutional role of the Federal Reserve in determining interest rates, especially long-term rates, but between 1979 and 1984 it was dominant. Insofar as the direction of long-term rates varied from monetary policy pressures, it reflected the prospect of a dramatic increase in the federal deficit during the 1981 budget debate and its ultimate long-term financing, which began in 1983.
In this chapter I will review the course of the treasury markets and the influence on them of the Federal Reserve, the budget deficit, inflation, economic growth, and the dollar. I will then examine how the volatility, size, and high returns of the treasury market made it a hothouse for the development of derivatives products and highly leveraged speculation.
The early 1980s were a fulcrum point at which the Federal Reserve's aggressive fight against inflation altered the trend of returns on long-term treasuries from a long period of negative nominal and real returns that