Trader’s Narrative

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?

I mentioned last week that there was a mad dash towards “risk free” assets, namely short term T-Bills which drove their price sky high and caused their rate to crash through the floor.

Looking at the long term chart for the 3 month US government treasury bills the recent market dislocation is awe inspiring:

Believe it or not, we’ve had the sharpest drop since the 1987 market crash (not shown on chart). On September 11th 2001 we also came close.

While the discount rate was cut by 50 basis points on August 17th 2007 to 5.75%. The Fed funds rate still stands at 5.25%, although most are agreeing that it will be cut sooner rather than later.

The distance between the short term bond market rate and the Fed funds rate is now astronomical. When I pointed out the increasing gap between these two important standards, they stood 48 basis points apart.

Now, that gap ballooned to 213 basis points before closing today at 166 basis points. This is a HUGE discrepancy. The Federal Reserve can not allow it to continue. The message is now clearer than ever.

When I wrote that the Fed should cut rates immediately, some (including me and myself) thought I was nuts. Now it seems eerily prescient. I don’t take credit in either case. All I’m trying to do is read the market and listen to its quiet whisper.