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Bond Market Signals Danger Ahead 8/21/7

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#1 TTHQ Staff

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Posted 21 August 2007 - 08:51 AM

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

Someone in the WallStreetWindow blog community made note Thursday on how the yield on a3-month Treasury bill dropped hard that morning. In fact the drop was shocking. The nextday the Fed lowered the discount rate and the stock market rallied. They lowered the rateto stabilize the drying up of liquidity in the financial credit markets and to help somelarge institutions that were heading into a financial black hole. As you can see from thechart below the yield on the 3-month Treasury bill collapsed yesterday. In the morning the3-month T-bills fell 150 basis points down to 2.5% and then bounced back up to a littleover 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 bigspike down in rates, but this move in the past few days has made that one look likenothing. The only time the yield dropped more Monday in one day is on the day of the 1987stock market crash. The sharp drop in three month Treasury bill yields suggests that theFederal 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 liquiditycontinues to dry up in money market funds and commercial paper.  The fear of furthercredit problems has made principal protection everyone’s top focus especially forbanks and money market funds that need to find a new place to invest after liquidity driedup 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 - furtherlending from other banks. The Fed has injected billions of dollars into the banking systemover the past few weeks and lowered the discount rate on Friday and it has had zeroeffect. Instead of making new loans with the money banks are hoarding it and using it tobuy the safest thing possible - short-term Treasury bills. They are thereby causing theprice 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 thenext six months.

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

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

One of my themes is that we are seeing things in the stock market happen internallythat we have never seen before. Yesterday was another one of these things. And that scaresme. 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.

You can listen to future podcasts as soon as they are recorded, instead of 24 to 48hours later when I post them on the website, by subscribing directly to the podcast's RSSfeed by clicking here.

A RSS subscription allows you to receive the podcast through your Ipod or RSS feedreader. I'd like to encourage you to subscribe to the podcast because the moresubscriptions to the RSS feed we have, the higher the podcast will be ranked in feeddirectories, thereby attracting more listeners to the program. We pay the costs for thispodcast which keeps it free for you, so your subscription to the podcast would be a greatway to help us out. And if you use podcast directories yourself, please don't hesitate torecommend us.

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