Bond Market Signals Danger Ahead - Mike Swanson (8/21/07)




Someone in the WallStreetWindow blog community made note Thursday on how the yield on a 3-month Treasury bill dropped hard that morning. In fact the drop was shocking. The next day the Fed lowered the discount rate and the stock market rallied. They lowered the rate to stabilize the drying up of liquidity in the financial credit markets and to help some large institutions that were heading into a financial black hole. As you can see from the chart below the yield on the 3-month Treasury bill collapsed yesterday. In the morning the 3-month T-bills fell 150 basis points down to 2.5% and then bounced back up to a little over 3% on the close. The yield closed down 18.51% in one day.



This is the biggest three day drop in the yield in the 3-month Treasury bill yield ever. In 1998 there was a flight to quality into three month Treasury bills that caused a big spike down in rates, but this move in the past few days has made that one look like nothing. The only time the yield dropped more Monday in one day is on the day of the 1987 stock market crash. The sharp drop in three month Treasury bill yields suggests that the Federal Reserve’s discount rate cut on Friday has not stabilized the creditmarkets, especially since one month yields hit a 3 year low. 

Investors are flocking to the safety of short term US government debt as liquidity continues to dry up in money market funds and commercial paper.  The fear of further credit problems has made principal protection everyone’s top focus especially for banks and money market funds that need to find a new place to invest after liquidity dried up in the commercial paper market. 

Let me put it to you this way. There is a liquidity problem in the banking system. There are banks that are dying in mortgage backed securities in need of water - further lending from other banks. The Fed has injected billions of dollars into the banking system over the past few weeks and lowered the discount rate on Friday and it has had zero effect. Instead of making new loans with the money banks are hoarding it and using it to buy the safest thing possible - short-term Treasury bills. They are thereby causing the price of bonds to rise and their yield's to collapse.

The bond market is also factoring in rapid and huge cuts in interest rates over the next six months.

You have to ask yourself what is going to happen between now and the end of the year to cause the Federal Reserve to lower interest rates by over 2%?

Today the Senate Banking Committee is going to meet with Fed Chairman Ben Bernanke in closed doors to discuss the swings in the stock market. They are scared. These yields have fallen so much that you think they would be due for a bounce. If they don't bounce they could knock the stock market down with them, but hopefully they bounce from here. What I'm interested in is what happens over the next few weeks. Are people going to be more bullish in the Investor's Intelligence figures, because they think the Fed has saved them? Will Treasury bill yield's stay depressed and forecast a looming recession and rapid and Fed cuts?

One of my themes is that we are seeing things in the stock market happen internally that we have never seen before. Yesterday was another one of these things. And that scares me. At the moment I do not want to own anything until this crisis clears.



Saturday morning I produced a new podcast titled The Fed Saved the Market from a Crash, For Now. Listen to it by clicking here.

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My goal in this most recent podcast was to wake you up to the risks in the stock market right now. Although I am becoming increasingly bearish on the broad market, I do think it very likely we'll see the market hold up for the next few weeks. I'm in cash and plan on waiting a few weeks before taking any positions on the long side. I might even take a short position at some point next month. If I was fully invested however, as I am sure most of you are, I would not sell now. But I would place stops on my positions - let Thursday be a lesson in the need for stops - and prepare myself to raise cash next month or hedge my positions at some point.