Monday, December 24, 2007

Spreads, Credit Fears and Principal Conservation

The following chart tracks the yield of 3-month US Treasury bills; recessions are marked in gray (click to enlarge). With the exception of 1984-86 when inflation came down rapidly due to plunging oil prices, every time T-bill yields dropped significantly the US economy entered a recession, or was already in one. The reason is that investors facing recessions get out of riskier assets such as stocks and corporate bonds and park their cash in T-bills, instead.

Three Month T-Bill Yield Chart:FRB St. Louis

The same thing is happening today, but with an important twist. The current credit crisis is targeting specifically the short end of the yield curve. The failure of the SIV - ABCP and other structured finance markets has increased demand for the safest possible short-term instruments, i.e. T-bills. While 3-month bills are now at 2.85%, bank certificates of deposit (CDs) with the same maturity are at 5.00%, 3-month LIBOR (the rate at which banks lend to one another) at 4.86% and commercial paper issued by financial institutions at 4.90%.

The spread between T-bills and such rates is the main credit fear indicator for money markets. The next chart shows the spread between 3-month bank CDs and T-bills (click to enlarge). It is at 2.15%, the highest in over 20 years.

Data: FRB St. Louis

However, even this big spread understates the magnitude of the current crisis because it is in absolute terms, not relative to current interest rates. It is one thing for spreads to be at 2.15% when market rates are at 10% and very much another when they are at 3%. For proper perspective, the next chart tracks the spread as a percentage of T-bill rates (click to enlarge).

Data: FRB St. Louis

The ratio is now at the highest point in at least 43 years (75%), meaning that investors are so concerned about getting their money back after three months that they are willing to forgo a record 75% more income available through CDs than from T-Bills (2.15%/2.85%). This is not mere credit fear, but full-out principal conservation mode.

Effectively, the money market has ceased functioning normally. Banks rely instead on borrowing unprecedented amounts from central banks and this explains the ECB's decision last week to provide "unlimited" liquidity and the Fed's announcement that it will continue its TAF operations for as long as it takes. The central banks have drawn a line in the sand, betting that they can ultimately win the battle against fear.

This is a very fragile state of affairs. Despite the rhetoric, even central banks do not posses enough resources to fund the entire system and one more wave of major credit-related news could easily wipe out the line.


  1. Hellasious,

    That Raio thing is a GREAT thought, putting things in perspective.

    Somehow the stock market is in a different world. Your stock analysis was good, but there is still a mystery cannot be explained: Overall SP500 earnings are down y-o-y and q-o-q, and it will be down next quarter too.

    But somehow SP500 and DJIA are very close to all time highs as if nothing has happened.

    I am not talking a few stocks holding up. I am looking at the big picture of all earnings combined.

  2. Re: Stocks

    Somebody's buying.. the latest suspect du jour is sovereign wealth funds. PPT writ large and in flashing neon lights. Who needs a secretive US-based PPT conspiracy when the governments of China, Singapore, the Gulf States and who knows who else are OFFICIALLY and PUBLICLY buying large slices of US companies?

    And that's just the stuff that is being announced, the big stakes. I bet there are many more smaller portfolio transactions taking place under it all.

    ..and if their govts. are buying into US stocks, why shouldn't wealthy but novice individual speculators from these countries be buying also? Think Arabs, Indians, Chinese.. with new-found millions and next to zero experience.

    It may be that there is a huge distribution operation unfolding here. If this is so, a lot of very angry foreigners are going to be left holding the bag.

    Watch volume patterns - e.g. in the past 18 mos. DJ went from 11.000 to 14.000 but average volume (# of shares traded daily) was actually lower than the previous 1-2 years. And lately volume has been expanding on the down days and contracting on the up days.

    But I am sure a lot of people see this already...


  3. Hellasious, great blog--how do you make those kinds of graphs in FRED? ie, graph a difference between two FRED datasets?

  4. Actually it appears that there's been a sufficient (ly large) amount of selling (of 3-mth Teasury bills) to send the rate back up by something like 30 bp.

    This is very big. And serves to move the 'TED spread' back in the 'safe' direction.


    Time = 1 Month
    Frequency = Daily

    So the question now is: who is selling?

    Since it's Dec-24 one might say this is a passing phenomenon (low traffic day). The thing to do though is watch the number for days following Christmas and into early Jan.

    But, if you're like me, you're watching it every day, multiple times.


  5. Hellasious,

    Thank's, looks like we can toss the old year end window dressing hypothesis out the window in this case, and same for any simple liquidity preference unless the latter = forced 'preference'.

    Happy holidays to you, family and friends.

  6. Its all a confidence game.

    The problem here is that the confidence game depends on "it all being contained to subprime."

    But, as anyone with more than a 20 IQ knows, its not.

    Its also auto loans, credit cards, Option ARMs (the next big implosion) and more.

    The "liquidity game" is really just one big scam. There has been no actual net injection. At all. Go look at ALL the data. You'll see it.

    But that's not what the media reports.

    And they DO know better.

    Is intentional deception punishable if "the media" engages in it? Probably not.

    But how well will that work out for you if you're one of the bagholders?

    You know the old saying - if you can't identify who the bagholders is.... its YOU!

  7. When the markets collapse "a lot of very angry foreigners" could be a much larger problem than is generally appreciated. U.S. companies have many properties in other countries and really angry foreigners have been known to seize our stuff before. Just something to consider.

  8. Re: making charts in FRED

    You can make combination charts by choosing other series in the space provided at the bottom of the page. Or you can downlowd the data sets in Excel and chart on your own.


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