Trader’s Narrative

The big new development today was the huge drop in short term Treasury bond yields. The benchmark 90 day T-Bill rate dropped to 0.005%. These are levels which we last saw just a few months ago when we were in the thick of the credit crisis:

The 30 day T-Bill rate 0.03% which is slightly higher than the double bottom it made in December 2008 and the end of October 2009 at 0.01%. And the 6 months T-Bill rate closed at 0.14% - a low it has seen twice before but is still jaw dropping. They haven’t seen these levels since 1958.

Even more shocking, for some short term government bonds maturing in January 2010 the rate fell to negative. I’m not sure why everyone is suddenly clamoring for US government bonds. Are they afraid that a new shock is coming to the stock market? is there some tragic news that is about to shake global financial market? or are major institutional investors simply afraid that the low interest rate environment and the dollar carry trade will inevitably lead to even more trouble?

And if so, how in the world is investing in US dollar denominated assets and trusting the US government in line with that sort of thinking? Honestly, I’m puzzled.

In any case, this is an important variable which isn’t getting as much attention as it deserves. One aspect of it is that it has an effect on the mutual fund cash level metric which we discussed before.

This is the where the level of cash held by US mutual funds acts as an indicator of market tops and bottoms. Usually it is adjusted to account for interest rates which need to be equalized to iron out the rewards during high interest rates and the punishment for holding cash in low interest rate environments.

While this indicator has been known and followed since it was introduced by Fosback in the 1970’s, I introduced an important improvement on this indicator - an idea that to my knowledge hadn’t been before; to adjust for real rates, not just nominal ones. Adjusting for the effects of deflation/inflation, mutual fund cash levels are actually very low - something which is bearish.

With this recent drop in benchmark rates, this metric drops even further into bearish territory and signals an even brighter red flashing light. And as persevering readers will remember, I cautioned that stocks had little room to the upside when the S&P 500 was at 1098.51 - it peeked above that level and has fallen again. We are now 17% above the long term trend. That’s a slight drop from 19.31% that we saw just a few days ago, but caution is still the watchword.

Just a few months ago we may have still been engaged in the economic debate of whether inflationary or deflationary forces would win out. On the one hand you had the credit collapse on a global scale which sucked the wind out of the economy and on the other hand you had the immediate and collective response of the Western world to inject mind-boggling amounts of money through monetary and fiscal stimuli.

But today the debate is over. In spite of the inflationary forces unleashed to fight it, deflation has cleary won. We are seeing this anecdotally on the ground as well as trickles of econometric data coming in from North America, Europe and even China.

The US economy is akin to a patient barely clinging to life in a critical care unit (insert US health care joke here). If the Federal Reserve is imprudent enough to raise interest rates from basically zero, it is not difficult to guess what might happen. Needless to say, they are not that stupid.

Even so, the Fed is pushing against a string at this point. They are basically observers like the rest of us, helplessly watching the largest decline in consumer prices in 50 years:

The chart below shows the real interest rate (interest rate minus inflation), rather than the nominal rate, its much more famous cousin:
Continue reading ‘The Necessary Consequence Of Deflation’

Back in October of last year, I looked with awe on an economic tsunami that was about to hit us all and wondered if it would be deflation or inflation.

Today, the answer is much clearer. Despite the gargantuan amounts of money that the central banks have pumped into the world economy through their loose monetary policy and despite the equally unparalleled coordinated worldwide fiscal stimuli provided by government spending, the danger of deflation is very real.

Just take a look:

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The decline in interest rates and more importantly in mortgage rates have been able to prop up the ailing US economy a little bit. But it seems that the short lived mortgage refinancing boom is over and will no longer be able to offer any support :

Keep in mind that the most recent data suggests that bond sentiment is extremely bearish.

The above chart is from the daily market commentary by David Rosenberg (sign up to receive it for free).

Today’s Bank of Canada rate decision is being watched very carefully. Not because of any lingering doubts about what they will do; because according to the rate futures there is a 100% expectancy of a 50 basis point cut (and a 73% chance of a 75 basis point cut).

The question on everyone’s mind is what will the six big Canadian banks do?

The last rate cut decision by the Bank of Canada resulted in a huge public relations mess for the Canadian banks because they refused to pass on the full rate cut to their customers. While the central bank lowered Canadian rates on December 9th, 2008 by 75 basis points, the banks grudgingly lowered their prime rates by only half a percentage point.

They have also refused to lower mortgage rates, citing “extraordinary credit market conditions”. This in spite of the fact that all stress measures of the credit market as well as money “costs” have fallen tremendously.

For example, the Banker’s Acceptance rate is now hovering around 1%. The 5 year bond rates are around 1.58% and the 30 year at 3.6%. Compare that to 5 year mortgage rates of approximately 6.75%-6.50% and you notice that that is a huge gap. In fact, according to historical data, Canadians have never seen such a discrepancy in their financial markets.

If the banks refuse to lower their prime rate again, the Canadian banks will not only widen the gap between the central bank rate and the “real rate” available to people but they will also negate any influence which the central bank is trying to have on the Canadian economy. In the end, by their belligerence, they could be pushing Canada into a deeper and longer recession than it would otherwise have to endure.

In that case, it would be a good idea for the usually soft-spoken governor of the Bank of Canada, Mark Carney, to call a meeting with the head of all Canadian banks and throw some chairs around.

Here’s a chart showing historical central bank rates for 7 major countries (Canada, US, ECB, Japan, England, Australia and Sweden).

UPDATE:
The Bank of Canada lowered its overnight benchmark rate by half a percentage point as expected. All Canadian banks followed by lowering their prime rate by the same amount to 3%, which means they are still 25 basis points behind the central bank’s lowering agenda.