Trader’s Narrative

One of the very few economists that foresaw the financial crisis was Canadian David Rosenberg. He was the chief North American economist at Merrill Lynch but recently moved back to Canada and joined the boutique asset management firm of Gluskin Sheff in Toronto.

While the FOMC has held the Fed Funds Rate at zero to 0.25 since December, a recent report prepared for the San Francisco Fed claims that this policy will have to be continued for much longer than first anticipated.

In a recent report, Rosenberg shows the chart below and points out that the Fed may very well have stopped easing. Although the Fed’s balance sheet exploded in 2008 as they went on a liquidity rampage, it hasn’t budged so far this year. The ‘real’ rate (adjusted for inflation) is closer to +0.77%, having rapidly recovered from the extreme low in late 2008:

There are several relevant variables to watch: the 3 month Treasury Bill rate; Dr. Copper - which has already signaled that the worst is over; and the Baltic Dry Index which has now surpassed the March 2009 swing highs and begun a new uptrend.

You can sign up to receive Rosenberg’s daily market commentary from Gluskin Sheff.

The Federal Reserve made a bold move and lowered rates effectively to zero. Here’s the full statement:

The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

It took a few years but finally they’ve moved in front of the bond market. As I’ve been saying for more than a year, the Fed allowed the bond market to get way ahead of it and then started to play a game of catch up where they would lower only to see the 90 day Treasury bill rate slip lower still.

To put it bluntly, the Fed is punishing saving and rewarding spending and debt. With inflation running at ~1% anyone who saves money is a chump. Many money market funds now have a negative return (due to MERs).

Anyone who goes in debt to the gills wins. Isn’t that how we got into this mess? you might ask. Well, who said common sense had anything to do with monetary policy.

Believe it or not, the US now has a lower interest rate than Japan. And the lowest rate since records have been kept.

After Japan, the lowest rate is claimed by Switzerland after the Swiss national bank cut their benchmark rate to 0.5% last week. Then Canada at 1.5%. Follow the link to see more global central bank rates.

NB: This would have been prescient had it been published when I wrote it: yesterday. But thanks to ISP downtime, it comes out now. The crystal ball seems to be working fairly well but perhaps it is time to change my connection to the tubes.

Everyone was waiting and hoping for major help from the Federal Reserve in the form of a rate cut. It was not really a question of will they or won’t they, but rather, when and how big would the cut be?

The Fed Funds futures already was discounting a 50 basis point reduction in the target rate earlier this week (by the next open market committee meeting on October 28th and 29th). So there was no real surprise there. Preempting the Fed, the Australian central bank cut their rates a full percentage point from 7 to 6%. They are also facing the aftermath of a real estate bubble which they allowed to get out of hand.

The global monetary spigot was turned on in synchronous fashion with the European central bank, Canada, Sweden, England, Switzerland each reducing their key lending rates. Even China got in on the action with a 0.27% cut in the 1 year lending rate - but they still have the highest rate at 6.93%.

The question now is, will that be enough? The central banks were already doing other things to help avert a total global financial meltdown. For example, the Fed started to pay interest on reserves held there by banks. Which in essence is a camouflaged Fed Funds rate cut. It also increased the existing term auction facility, which has become an alternative to the discount window used by banks.

The key is not that there was a cut, nor that it was synchronized. But that it was very much expected. So it did not take the market by surprise. Had it been unexpected (how, I’ll leave up to you) or had the rate been reduced by a much larger amount than most expected (say a full percentage cut to 1%) then we would have probably seen the market rally in response. There was only a 40% probability (based on futures market activity) that the Fed would cut 100 basis points before the end of the month. So the market would definitely have been surprised had that happened.

I’ve been pointing out the gap between the Fed Funds rate and the 90 day Treasury Bill rate set by the bond market for a long time now. According to this metric, the Fed has been simply asleep at the switch. The cut should have come a long time ago to narrow the growing gap. But now it may be too little, too late.

The scenario I wish we had seen was one where the Fed would have lowered the rate dramatically about 2 months ago, proactively. And gotten in front of the short term rate set by the bond market. They would have probably had to have kept this rate for a short time (less than a year) but it would have made a dramatic difference because for once, they would have been calling the shorts, rather than being led by the nose.

The danger is that while technically today’s news should help matters, from a psychological point of view, it makes it appear that all the major central banks in the world are desperate. And if they are not successful in stabilizing the credit markets, then they will appear to be in the worst possible position: powerless.

And that is what no one wants to see.

The 3 month Treasury Bill rate is an important fixed income security that I keep track of, not because I trade it but because it is a remarkably accurate gauge of panic in the equities markets. It is also very prescient in leading rate changes by the Federal Reserve board.

Thanks to its predictive qualities, I said that the Fed should lower rates as far back as last summer. When I show most people the data that proves that the Fed actually chases after the bond market they are astonished. Even a lot of traders aren’t aware of the real relationship between the bond market and the Fed.

In any case, just a few weeks ago this important rate was close to 2%, where it had been followed lower by the Fed Funds rate. But now it is 0.03% !! Two things stand out: a drastic move in a short time frame, and the fact that this is as close to zero as you can practically get. Unless I’m wrong, this is the lowest rate the US has seen for this fixed income security.

To give you an idea of the magnitude of this, here is a very long term chart of the 3 month Treasury Bill covering many other financial crisis:

The chart is logarithmically scaled so each move shown is standardized as a percentage. Notice how the 1987 crash, the September 11th attacks and ensuing chaos hardly register when compared to what we are witnessing now.

Ben Bernanke famously quipped that as a last resort the Federal Reserve could always drop dollars from a helicopter… if you listen carefully, you might just hear the whine of the engines warming up for takeoff.

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.