Trader’s Narrative

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.

What are CDS’ and why should you care what their rate is doing?

Credit default swaps are financial instruments which transfer the risk of a bond issuer defaulting from the seller of the instrument to the buyer. Although they are infinitely more complex, think of them as put options. Just as being long a stock and a put protects you from the downside, so does a credit default swap protect the bond holder from catastrophic loss due to default.

This is a relatively new financial instrument but it’s market is growing like crazy. Of course, it is off limits to regular traders and investors due to its complexity and size. Yet just by watching this interesting market we can get an inkling into the animal spirits driving a market.

By comparing the credit default swap rates to a theoretically risk free security like a Treasury bill, we can track how much risk is being tolerated out there.

The more market participants perceive risk, the more premium they will demand for taking it on. And so the spread between the two rates will widen. And the less risk perceived, the less premium and the spread will collapse.

Although this is a young indicator, it has shown promise. Check out this chart of the S&P 500 index. The green arrows point to when the spread between credit default swap rates and risk free rates widened both significantly and within a short time. That is, a quick and large move.

As I briefly mentioned last week when commenting on the Bear Stearns (BSC) sub-prime debacle, credit default swaps were taking it all in stride. But from then to now, they have indeed moved sharply.

Why now? and why not last week? I have no idea. All I know is the bond market is now more frightened of defaults than it was then. And that is actually quite bullish for equities going forward.

Data and indicator courtesy of SentimenTrader.com