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Credit Market Update For The Week - Bond Market Dislocates

Clearwater Florida I know we're all a little dizzy from the Stock Market plunge this week - so are you wondering what caused this to happen? 

Here's an excellent article by Matt Heaton on why it happened and what we might see next.  

Sorry, I didn't get a chance to do updates during the week, things were moving so fast that I barely had the time to keep on top of them myself.  Pretty much everybody is fixated on the "crash" in the stock markets with major US indexes plunging about 17% on the week, but equity markets are just a symptom, it's important to look at the cause. 

The deterioration in the credit markets on a daily basis was simply stunning, and resulted in a near lock down of both intrabank lending and financial commercial paper markets by the end of the week.

Bond market dislocates

We saw what is referred to as a dislocation in the bond market early this week, and these types of dislocations, historically without fail have lead to stock market crashes.  Basically we had money fleeing long term US treasury bonds, causing their price to plummet and thus the yield to increase.  This happened at the same time the opposite occurred in short term US treasury bonds as people flocked to safety, and at times in the week even drove the yield on 13 week treasuries negative (yes it is possible). 

There is a very strong correlation between equities (stocks) and bonds, as money moves out of stocks it typically moves into bonds and vice versa.  So if stock prices are going up, bond prices are going down.  We saw this correlation totally destroyed this week, as stocks were crashing, long bond prices were plummeting (yields increasing). This indicates capital (probably foreign capital) fleeing long term US treasuries.  Chart below of the ten year treasury yield and second the DOW during the week. Yes, this is VERY bad.

What caused the dislocation?

Simply put it was CAUSED by the $700B bailout and the FED's buying of the commercial paper early this week.  The reason is simple supply and demand economics. It was something many people saw coming and I mentioned was one of the reasons I was so adamant the bailout had to be stopped.  The bailout means the US Treasury has to issue significantly more long term US Treasuries to fund it at the same time the demand for them is staying essentially flat or possibly even decreasing.  Increased supply with flat demand means prices of long term treasuries are going way down and yields (interest rates) are going way up.  It's not rocket science. Even though the treasuries have yet to issued the bond market is beginning the process of pricing it in.

The more we try to bail things out the higher we will force long term interest rates, ultimately extending and deepening the real economic pain.  If the stock market had not crashed at the same time forcing money into bonds to hide, we would have seen an absolute explosion in long term rates this week.

What does it mean?

As a real estate agent or loan officer the implications will probably scare the you know what out of you.  Rates are almost certainly going much higher over the next few months, and I think there is a probability of a 1930's style bond market collapse being triggered.  If this type of bond market collapse does occur, we're not talking a 1 or 2% increase in rates, I'm talking at minimum double where they are now and in the space of a year.  Yes, I know it that seems improbable, but it's happened before under similar circumstances.

Below is a chart of the 1930's bond market collapse, and we are almost matching the event chain and timing perfectly (we're finishing the flight to quality stage).  While i hope history does not repeat, our policy makers seem dead set on following the exact same ill fated path and the bailout may have pushed us across the event horizon.

 

* Lower bond prices mean higher yield/interest rates.

Credit market indicators

I mentioned above many indicators of stress in the credit markets went through unbelievable deterioration on a daily basis during the week.  One of the main ones I watch is the TED spread which is the spread between 3 month treasury yields and 3 month LIBOR rates.  The higher it goes the more stress. This is because short term treasury yields drop in times of fear because they are considered the safest place to stash money while LIBOR will increase as banks become more fearful of lending.

The long term average spread is about 30 basis points and anything over 200 basis points is crisis mode.  We started the week at 382 basis points and continuously ramped to finish at 464 basis points.

As indicated by TED spread LIBOR rates continued to explode during the week.  Overnight LIBOR rates ramped to well over 4% as banks became fearful of lending to each other, until collapsing on Friday due to coordinated central bank action.  But 3 month LIBOR continued on it's ramp and is now close to double what is was a couple months ago. LIBOR rates are extremely important because there is over $300T in worldwide debt that is in someway tied to these rates.  So they go up, borrowing costs for banks and businesses go way up, and almost every business is reliant on credit to some degree.

From a banking perspective banks often borrow at LIBOR and lend at a rate tied to the the FED's target rate.  So the increasing spreads and other effects on the yield curve are absolutely destroying the ability of the banks and other financial institutions ability to make money.

Other significant events

* Iceland's banking and financial system collapses during the week forcing them into official bankruptcy on Friday

* Hungary's bond market collapses

* Japan's main banks began firewalling themselves off from other world banks and refusing to lend

* World equity markets plunged, in most cases worse than US's, with trading suspended indefinitely by several of them including Russia

* G7 meetings going on this weekend and everybody is scrambling for a solution

Stock market stuff

Even though I'm a very active trader myself I generally avoid talking about stock markets on my blog here at ActiveRain.  I try to keep it to credit markets that have a direct impact on rates and loan availability and thus the real estate industry.  The stock plunge we've seen in the last couple weeks has certainly been pretty devastating, for comparison here's the 2000 dot com crash on a monthly chart vs. our current one.

For many reasons both technical and fundamental I think we are very overdue to a violent snap back rally in this bear market, possibly starting this week, but we probably have a long ways to go still before we put in an ultimate bottom.  So be safe...

Comment balloon 5 commentsCyndee Haydon • October 11 2008 05:54PM

Comments

What an excellent Re Blog Cyndee.  Many people visit your blog, so it is great that you placed this information here.

Katrina

Posted by Katrina Madewell, Tampa FL Homes for sale | Tampa Bay - (813) 777-1196 (Charles Rutenberg Rlty- More than 5,000 agents(813) 777-1196) about 10 years ago

Excellent repost on the Credit Market Cyndee & Jack. Thank you for sharing and stay the most consistent Clearwater Beach Short Sale Agent. Keep up the good work.

Posted by Katerina Gasset, Get It Done For Me Virtual Services (Get It Done For Me Virtual Services ) over 5 years ago

Informative article you have here Cyndee & Jack. Thank you for reposting this on your active rain site. All the best.

Posted by Petra Norris, Realtor, Lakeland FL Homes for Sale (Lakeland Real Estate Group, Inc.) over 5 years ago

Great stuff on the Credit Market. Very knowledgeable and informative. Keep them coming Cyndee  & Jack. 

Posted by Melissa Muse Wiggans, CRS, GRI, ABR - Real Estate Muses (Real Estate Muses) over 5 years ago

Impressive repost Cyndee  & Jack. Hope many of your avid reader and followers were able to find this post informative as I did. Thank you for sharing and stay the most reliable Clearwater Beach Short Sale Agent. 

Posted by Waynette Hoover Araj, Connecting your Dreams with the Right Real Estate (Keller Williams Realty) over 5 years ago

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