Short-Term Interest Rates
The recent breakdown in long-dated bonds was interesting and potentially significant, but the action at the short-end of the market has been even more interesting. What we are referring to is the extraordinary divergence since mid March between the yield on a 3-month T-Bill and the yield on a 2-year T-Note, with the 3-month yield falling from 4.85% to 4.55% in parallel with a rise in the 2-year yield from 4.55% to 4.97%. The following chart illustrates the divergence.
(http://www.bloomberg.com/markets/rates/index.html)
We are confident that the Federal Reserve is not the driving force behind the recent strange decline in the 3-month interest rate. The way we see it, the Fed is concerned that the ‘inflation genie’ could soon escape from the bottle and would almost certainly prefer the 3-month yield to be where it would normally be: near the Fed Funds rate target (currently 5.25%).
For its part, the Fed has been doing what it needs to do to keep the effective Fed Funds rate near the official target rate — adding reserves to the banking system whenever the actual rate moves above the target rate and removing reserves from the banking system whenever the actual rate falls below the target rate — and is, we suspect, a little miffed that the market has pushed the 3-month interest rate down to the point where it is trading at a 70 basis-point discount to the Fed Funds rate.
In other words, we don’t think the Fed is fighting its own monetary policy.
We are also confident that the market’s anticipation of Fed rate cuts is not the reason for the 3-month interest rate being at such a low level relative to the Fed Funds rate. This is because the December-2007 Fed Funds Futures contract is currently priced as if there were almost no chance of an official rate cut before year-end. In fact, as the 3-month T-Bill yield has declined from 4.85% to 4.55% over the past 2.5 months the December-2007 Fed Funds Futures contract has gone from discounting two 25 basis-point rate cuts to discounting no rate cuts.
So if the T-Bill discrepancy is not the result of meddling by the Fed or the market’s anticipation of future Fed rate cuts, then what’s causing it?
One explanation worth considering is that T-Bill yields have been pushed downward in response to a temporary supply shortage, which, in turn, has stemmed from higher-than-expected tax revenues (the higher the tax revenue the lesser the quantity of new T-Bills issued by the Treasury). That is, an unexpected fall in T-Bill supply due to the actions of the US Treasury could theoretically have caused T-Bill prices to rise and T-Bill yields to fall. We don’t favour this explanation, though, because we suspect that under such a scenario there would be temporary downward pressure on the yields on all short-dated Treasury securities, not just T-Bills.
In our opinion, the Yen carry trade is the most plausible explanation for the recent anomalous decline in T-Bill yields (and many of the other strange happenings in the financial world over the recent past). We doubt that it’s a coincidence, for example, that the dramatic divergence between 3-month and 2-year interest rates since mid March has been accompanied by a relentless slide in the Yen. With credit spreads having shrunk to almost nothing, perhaps carry traders have begun to direct a greater proportion of their Yen borrowings toward one of the world’s lowest-risk and most liquid markets — the market for 3-month US Treasury Bills.
Current Market Situation
We have again included a chart comparison of the S&P500 Index and the euro/Yen exchange rate in today’s report, because as far as the stock market’s short-term trend is concerned it continues to seem as if euro/Yen is the only thing that really matters. This past week, for example, the euro hit a new high relative to the Yen, thus enabling the S&P500 to ignore a sharp correction in China’s stock market and end the week at a new high of its own.
One of the reasons we can’t embrace the stock market’s relentless advance is that we expect the Yen to soon reverse course against both the euro and the US$. But at the same time, we aren’t keen to step in front of this fast-moving train.
A risk facing the stock market that we’ve mentioned quite regularly over the past few months is the risk of a breakdown in the bond market. The stock market ignored last week’s move to new 9-month lows by bond futures, but falling bond prices always have an adverse effect on stock prices in the end; at least, they always have in the past.
Another risk — one that was ‘brushed off’ last week — is that China’s stock market bubble will soon burst. China’s Government has sent a clear message that it will do whatever it takes to halt the stock market’s parabolic rise, so we can be sure that if last week’s small (0.2%) increase in the tax on share transactions doesn’t work then something else will be tried. A large decline in China’s stock market would take a toll on the US stock market, although it would probably take a bigger toll on emerging market equities and industrial metals.