Markets Forcing The Fed Into Rate Cut?

A: I have to stick to more heavily weighting macro discussions on urbandigs while so many changes are taking place. Its just very important to explain to you why things happen. Right now, the short term US Treasury markets are rallying bringing yields WAY WAY down! Normally, the spread between the 3 Month T-Bill and the fed funds rate is about 50 - 75 basis points (0.50% - 0.75% spread in yields). We know that the fed funds rate stands at 5.25% right now, but 3-Month T-Bill is now yielding below 3%, over 200 basis points spread! This is the markets way of forcing the feds hand into a rate cut, and it may just work!

First off, there is much debate about whether this is the markets way of forcing the feds hand, a repricing of assets to quality and out of anything associated with risk OR the markets overshooting as they normally do which will ultimately correct itself. In either of these cases, its worth discussing.

Check out what the 3-Month T-Bill yield has done over the past 4 weeks; just an amazing rally in bond price and subsequent steep selloff in yield (a drop of over 240 basis points or 2.4%!). I circled the yield change from last month to yesterday for ease of interpretation.

This discussion focuses on the 3-Month T-Bill, whose yield movement over the past 30 days I just circled above, and the spread that this short term yield now has when compared to the fed funds target rate of 5.25%; I discussed credit spreads widening about two weeks ago. Historically, the spread between these two instruments are about 50-75 basis points OR 0.50%-0.75%. However, in the past 30 days due to the repricing of risk, the spread between these two has gapped to about 240 basis points. Reasons why could include:

1. T-Bill Markets Are trying To Force The Fed To Cut Rates To Normalize The Spread
2. Short Term Treasury Yields Are Experiencing A Flight To Quality As ALL Risk Is Avoided
3. Short Term Treasury Yields Are Pricing In Severe Deterioration In Economic Conditions
4. Short Term Treasury Markets Are Overshooting & Will Correct As Risk Repricing Continues

Yesterday alone, the 3-Month T-Bill experienced the steepest decline in yield since the crash of 1987; the T-Bill yield was down by a full percentage point before recovering!

MoneyAndMarkets has a great peice on what is going on in the short term T-Bill markets yesterday:

Some of the world's largest and most "professional" investors, so cozy in their complacency just days ago, are dumping short-term loans (commercial paper) like hot potatoes, especially those backed by mortgages.

* The 1-month T-bill rate has plunged from 4.52% last Tuesday to as low as 1.25% today. That's not a typo! It was actually down by more than THREE full percentage points in just four trading days!

* Today alone, the 3-month T-bill rate was down by over one full percentage point before recovering a bit.

* The all-critical spread, or difference, between the 1-month T- bill and 30-day commercial paper rates is now as much as THREE times bigger than it was just a few days ago - another confirmation of panic in these markets.

They list 5 reasons why this is happening and what this could mean to you:

First - even investors in the shortest-term debt market are shunning any kind of loans with risk attached to them. They don't want sub-prime paper. They don't even want prime paper. They just want ultimate safety - short-term Treasury bills backed by the full faith and credit of the U.S. government.

Second - if you've got a chunk of your nest egg in one of our favorite short-term Treasury-only money funds, good. It means you already own what nearly everyone else now wants.

But if your fund has an average maturity of just a few days, don't be surprised if your yields start dropping sharply very soon.

Third - don't be surprised if the panic in the U.S. money markets soon becomes a panic in the U.S. stock market. Heck, if investors think normally-safe commercial paper is so risky, why should they believe stocks are any less risky?

Fourth - with the yield on U.S. Treasuries plunging, watch out for another, even more severe plunge in the U.S. dollar, especially against the Japanese yen.

Fifth - brace yourself for more. Today's panic in the money markets is just a sampling of what's possible in the days ahead.

Personally, I think the markets will successfully get what they want: A FED MOVE! I expect a fed rate cut in September UNLESS tradable markets show a bounce and close near 13,400 or so by the next meeting. However, I dont expect that. I expect uncertainty to continue and volatility to be high as markets re-price risk. I think there are many hedge funds, lenders, and banks still yet to come out with their holdings. The fed may have to move sooner rather than later and an intra-meeting rate cut is certainly possible. It's going to be a wild few months!

**Investors.com: 3-Month T-Bill Yield Sees largest Drop Since 1987 Crash Amid Flight To Safety

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