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.

Today we’ll be keying off only one market tell: the scheduled Federal Reserve rate cut decision.

I’ve been following a simple model of the Fed’s actions: approximation of the 90 day US government T-Bond yield. At yesterday’s close, the 3 month US Treasury Bond’s yield was 2.280% and in overnight trading they were a bit lower at 2.20% (last time I checked).

Here’s a recent graph comparing it with the Fed rate (in blue):

If only they’d listened to me when I suggested they cut, way back in the summer of 2007!

The Fed is now way behind the curve and in a desperate (some say futile), last ditch effort to forestall a recession in the US economy. I know this sounds crazy but they would have to cut 125 basis points to bring the Fed target rate in line with the bond market - see above graph.

The odds are that we will get a generous rate cut. But probably not that generous. According to Federal Fund futures, we have more than a 70% chance of a 50 basis point cut and about a 30% chance of a quarter point cut. But really, no one knows what the Fed will decide.

All I know is at 2:14 pm today, the futures will go nuts. Since the market is clearly expecting (and needs atleast) a 50 basis point cut, anything less will be a major disappointment. If we get anything more, we could be riding a rocket. The market is clearly in a very oversold condition and a catalyst like an unexpectedly larger rate cut would be all it needs to recover. If we do get exactly 50 basis points, we could flail around and end the day unchanged for the most part.

In any case, the first directional jab is usually a head fake, or has been in the past. So unless you really really have to don’t trade around the decision time.

If you do, just know the risks. Including the risk of losing internet connectivity, losing power, etc. Believe me, you don’t want to be stuck in a position that can move against you mercilessly unless you have planned for every contingency.

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?

While the US market was closed for Martin Luther King day, markets in Europe declined in what can only be described as a panic.

Lets throw some scary numbers around: Toronto fell almost 5%, Mexico -5.4%, the MSCI World Index fell 3%, the European Stoxx 600 -5.7%, the FTSE -5.5%, the DAX more than -7%, in Spain IBEX 35 fell 7.5% - the largest single day decline since the founding of the index in 1992!

The classic definition of a bear market is any decline of 20% or more. By those concise parameters there are quite a few countries who are now in a bear market:

Argentina
Australia
Austria
Belgium
Chile
Colombia
Denmark
Finland
France
Hong Kong
Iceland
Ireland
Italy
Luxembourg
Mexico
Netherlands
Norway
Portugal
Singapore
Spain
Sweden
Switzerland
Turkey
and a few others…

The best advice is to keep one’s head while others are losing theirs. But as with all good advice, it is more easily given than put into practice.

Tuesday’s market should be interesting, especially since we are going to see a gap down of considerable proportions:

But from where I’m standing, things look a bit too emotional in the market. Suddenly here is a lot of talk about the “c” word - which could create a self-fulfilling prophecy if enough people believe it. But I’ve already covered the recent sentiment picture, so no need to repeat myself.

To contrast with that raw emotion, consider the cold reality that stocks are actually undervalued (according to the IBES valuation method). Also, the MSCI World Index has a 14 PE ratio (the lowest since 1995). And Europe, even more so with the Stoxx 600 having a PE ratio of 11 (a level it previously held in 2002).

But you can’t expect people to be rational. The only catalyst that can potentially turn things around here is either the fabled PPT or a “surprise” Fed rate cut of at least 50 basis points. But the rate cut is at this point not much of a surprise, even though I think the market will take what it can. In the end, we may get neither and the market will have to work its way through every last hopeful trader and investor until there are none left.

I’ll be watching the opening range in the market - including the overnight trading since it is heavily traded. That may be a good market tell for the day we are in for.

okay, lets get started… here is this past week’s sentiment overview:

Retail Investors Soil Pants
That’s not the sort of headline you’ll find in any newspaper but it is true nonetheless. The most eye popping sentiment data this week comes from AAII where only 20% of the survey respondents are bullish and 59% are bearish.

The last time we had so small a group of optimists was January 1993 and May 1993. But even then, the number of undecideds was larger. Right now we have as severely a lopsided sentiment picture as ever. The “dumb money” is crowding to one side. The question is, where do you want to be? with them? or on the opposite side?

Before you answer, check out the chart of the S&P 500 Index (SPX) showing what happens when we have more tan 50% bearishness in the AAII survey:

I may have been a bit early when I wrote “Time to Buy” but I did add that a market rally was around the corner. I think we’re rounding that corner now.

ISEE Sentiment Index
At the start of the year I got concerned that the retail option traders were too excited, buying up calls and shunning puts. We now know that the market dipped right after. Yesterday the ISEE Index pulled back to 72 - meaning only 72 calls are being bought for every 100 puts.

That’s not as low as I’d like to see it but the market has turned around at these ratios before. Check out my intro post on the ISEE sentiment index.

Fed Rumours
Of course, it didn’t hurt that there were pervasive rumours of a surprise Fed rate cut this week. Who knows who starts these things? eh, Doug Kass? I wonder if you know?

And wouldn’t you know it? In a Washington speech, Bernanke practically came out and said that rates would be cut more aggressively - “Fed speak” for half and 75 basis point cuts. Which is what I’ve been droning on about for too long.