Trader’s Narrative

Since I’ve been harping on about the gap between the Fed Funds rate and the 3 month Treasury Bill rate for almost a year now, I thought that it would be fun take a really long term look at their relationship.

Here is a chart of the difference between them going back more than 18 years:

There are several things that jump out from this cursory analysis:

• what we just went through was extraordinary
• spikes tend to correspond to stock market turmoil or bottoms but not always
• over the time covered, the average gap is 29 basis points
• under Bernanke, the gap has been larger & more protracted than Greenspan
• rarely does the 3 month T-Bill rate go lower than the Fed rate
• Fed responded very quickly to financial shock of 9/11

Since I’m lazy I used the historical data readily available from Yahoo! Finance but I’d appreciate someone with access to cleaner data from Bloomberg or Thompson to corroborate the results.

The most important thing to take away from this is that there definitely is a relationship between these two financial instruments. Their long term average difference is so small: 28.9 basis points. And they tend to follow each other around most of the time. This isn’t surprising though since just a glance at the two charts side by side going back to the 1940’s shows their relationship.

This indicator may be useful as a tool to gauge financial shocks, and by corollary, buying opportunities. But since the attitude and responsiveness of the Federal Reserve chairman in power can influence how fast they respond to the market rate, it isn’t that objective.

At best it is just a starting point for further study. If you play around with it and find something interesting, drop me a comment to update me.

So the Fed had a working weekend. On Sunday they cut the discount rate by a quarter percent to 3.25% and today, they cut the Fed Funds rate by 75 basis points to 2.25%. The market almost unanimously rejoiced and rushed to buy with both hands, eventhough the Fed Funds futures indicated most were expecting a full 1% cut.

Is that enough? are we out of trouble now?

I don’t think so (just yet).

One of the theories of why we are in such a fine financial mess today is that we’ve had lax monetary policy. I’d like to propose another, without necessarily disagreeing or disproving that school of thought.

It goes something like this: while lax monetary policy is bad, what we are dealing with now isn’t just the after-tremours of the Greenspan bubble era. Since his first days as Chairman, Bernanke has refused to listen to the bond market.

By ignoring it, he has compounded the problems that were there to begin with. And instead of giving the economy the flexibility it needs to go through a short transition period to “fix” itself, he has in effect, extended this painful process (indefinitely).

I’m referring to Bernanke’s insistence to remain, month after month, firmly behind the 3 month Treasury Bill rates. This is something that I noticed last summer, when I wrote that the Fed should cut rates immediately.

And if you take a look at this long term chart of the Fed funds rate compared to the 90 T-Bill rate, you can easily compare the Bernanke Fed to the Greenspan Fed. Greenspan let the market lead him by the nose. His talent was in making every one believe he was in charge… the Maestro, orchestrating the economic symphony, while in fact, he was just flailing his arms around randomly.

Which brings us to today’s interest rate cut:

Unfortunately, since last month the gap has gotten worse! The Federal Funds rate gap is now 133 basis points away from what the short term bond market is saying it should be at.

So while another 75 point basis cut is dazzling, until the Fed actually gets in front of the short term bond market for at least a day or week, I can’t see this mess getting mopped up.

And believe you me, there is a fine mess out there. The Bear Stearns(BSC)/JP Morgan Chase (JPM) story has grabbed everyone’s attention but there is a lot more happening out there:

MF Global (a subsidiary of MAN Capital) was taken behind the toolshed
Carlyle Capital Corporation is about to go tits up
Hedge funds and private equity funds are being closed right, left and center

So on the one hand, things are darkest before dawn but on the other, the way Bernanke is dragging his feet worries me.

As the Fed Funds futures indicated, we got a 50 basis point cut. And since this was what the market expected and had come to rally for ahead of time, we got a muted response. I wrote early this morning:

“If we do get exactly 50 basis points, we could flail around and end the day unchanged for the most part.”

The text of the Fed announcement hints that there will be more rate cuts to come:

Today’s policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.

The Fed’s scramble to lower interest rates is much more than just a preoccupation with the housing market or the stock market slide or the liquidity crunch or the multi-billion dollar Societe Generale fraud or any other one variable. It is about the US economy’s inevitable slide into a recession.

With the interconnectedness of world economies, you can bet this will quickly seep into Europe and Asia. I’m already hearing from friends and family overseas that business is slow.

Here’s an updated graph from Google Trends:

Notice how the first blip coincides with the Asian “flu” correction in the spring of 2007. But now its off the charts!

You’d have a headache too if you had his job.

We’ll never know how the market would have traded without the Fed rate cut but I have a feeling it didn’t make much of a difference.

I’ve been telling the Fed to cut rates since last summer so if you’re one of my 4 long term readers, this is not new to you.

The Fed is continuing to chase the bond market in a cat and mouse game. Only problem is that the Bernanke Fed has been unwilling to do what is really necessary to bring the discount rate to alignment with the bond market.

It is the Fed that actually mimics the interest rate as set through the bond market (not the other way around). Today’s “surprise” 75 point basis cut may seem huge by historical standards but if you compare it to the short term T-Bill rates, you’ll see that much more is needed.

Greenspan had a much better track record in keeping the Fed discount rate as close as possible to that set in the bond market. See how close the black Fed rate hugs the blue short term bond market rate?

Since Bernanke replaced Greenspan in February 2006, we’ve seen a significant decoupling between the two. From early 2007 till now, the short term bond market has been consistently and significantly below the Fed rate.

This has exacerbated the liquidity crisis and it will continue to do so the longer it lasts.

The “risk free” three month Treasury Bill rate closed at 2.35% today. That’s 115 basis points below the brand spanking new discount rate of 3.5%

All the Fed has done is cut the gap between the short term T-bill from 139 basis points (Friday) to 115 basis points (today).

Can you imagine what the market would do if Bernanke & Co. came out with a cut that size?