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.

The market got spooked today because of the release of the Fed minutes (April 30th meeting) showed a hawkish bent. First, I don’t think the market fell because of that. I’ve been cautious for a while now due to a number of technical and sentiment indicators.

But the reluctance of the Fed to continue cutting may not be a bad thing. For one, take a look at the comparison between the Fed Funds rate and the 3 month Treasury bill rate:

It is like the reunion of two lovers (this is as romantic as a trading blog can get). These two financial metrics usually go hand in hand but for far too long there has been a historic dislocation between them. I first pointed this out last summer: Fed should cut rates immediately.

The fact that now we are seeing the bond market and the Fed Funds rate return to their normal behavior bodes well. Especially considering the financial turmoil we’ve endured so far. Believe it or not, at one point they were 133 basis points apart!

And now we are down to just 14 basis points.

I know this is a very simplistic way of looking at an incredibly complex matter but what can I say? I like simple things. I prefer to allow the market’s voice, through the 3 month T-Bill rate, show me where the interest rate should be. I definitely think they do a much better job than a committee of economists harrumphing around an oak table.

I would have preferred the Fed to have taken the rate below, even if just a smattering, the bond market set rate. But I doubt that will happen. We can just settle for the fact that instead of the previous pattern of running away from the Fed, the bond market is now heading towards it in what seems an inevitable reunion or perhaps, even
a crossing.

After almost two years of estrangement, that calls for a celebration.

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?