Option Investor
Market Wrap

Inside the Head of the Fed and the Senate

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Several subscribers have recently pondered my ties with the Working Group, which was later coined the name "Plunge Protection Team" by a Washington Post editor.

While late-night meetings I had on Wednesday, and my Thursday afternoon mentioning that the Fed may be set to cut rates prior to Friday's opening bell may appear suspicious to a few OptionInvestor.com Market Monitor subscribers, I can only assure you that my comments were centered around the recent bond market trade, and to an extent, an understanding of how the Fed works, and what its primary goals are.

Friday morning's lowering of the Fed discount rate by 50 basis points to 5.75% was a short-term attempt by the Federal Reserve to narrow the spread between the primary credit rate and the Federal Open Market Committee's target for federal funds rate to 50 basis points.

I want to stress "narrow the spread between the primary credit rate and the FOMC's target for the federal funds rate."

Based on tonight's closing for various Fed Fund futures, starting with August's (ff07q) 94.99 (100 - 94.99 = 5.01%) and September's (ff07u) 95.09 (100 - 95.09 = 4.91%), as well as today's bond market action, still suggests the Fed has further work to do.

In the above U.S. Market Watch, I specifically point to the very short-term 13-week Treasury Bill Yield ($IRX.X), which fell sharply again today by 67 basis points to close at 2.950%. You do NOT need to be a bond market "expert" to understand what a sharp decline that is, nor what it tends to say about a continued "flight to safety."

Imagine for a moment that you called your local bank on Friday afternoon for a quote on what their money market account might be yielding and they quoted you 3.62%. This afternoon you arrive at the bank and the head teller is now changing their signage to read, "Ask us about our 3-month 2.95% CD!"

At its lowest yield of the day, the 13-week Treasury Yield ($IRX.X) plunged as low as 2.40% just after 12:30 PM EDT.

Closing Internals -

Tonight, I've added the very short-term 13-week Treasury Yield ($IRX.X) to my intra-day internals, in order to show you HOW the EQUITY markets are "keying" on the Treasury bond market action.

I could NOT critique the FOMC one bit for its decision to lower the discount rate by 50 basis points Friday morning, but the "hunger for" a 2.95% 13-week yield, and steady appetite for a 5-year ($FVX.X) yield of 4.302% at today's close still suggests market participants are avoiding higher risk securities, and are instead willing to accept a LOWER yield from one of the "safest" U.S. asset classes available.

While my hourly benchmarks do not fall on the 1/2 hour, we can begin to see the "widening of the spread" between the 13-week and the 5-year ($FVX.X) Treasury Yield from their respective 11:00 and 01:00 Benchmarks.


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Equity prices deteriorated toward the 03:00 PM EDT Treasury bond market close, but pared losses as if equity traders "lost their read" from the bond market.

Unfortunately, QCharts does not have a symbol for the U.S. Treasury 2-year Yield, but here is a "close" snapshot of 2, 3, 5, 10 and 30-year Treasury prices, and their respective yields at 04:26:11 PM EDT.

2-year thru 30-year Treasury Prices/Change/Yield/Change

At Friday's close, the 2-10-Yr Yield Spread did mirror a 50-basis point spread, but that spread started to widen a bit to 53 basis points at today's bond market close.

13-week Treasury Bill Yield ($IRX.X) - Daily Intervals

In Friday's Market Monitor, I began devising a "test" for the Treasury bond market. With the 13-week Treasury deemed MUCH safer than a 6-month, or 2-year, or 3-year or 5-year (longer time horizons allow for greater uncertainty, thus "riskier") I wanted to mark a RANGE of retracement.

My LOWER end of the RANGE should be marked at Thursday's low of 32.50, or 3.25%, which was prior to the factual news of the FOMC's decision to lower the discount rate by 50 basis points.

Most would agree that the lowering of the discount rate, or even the fed funds target rate, would/should have had greater impact on the Treasury bond market than an intra-day repurchase of securities like that found on 08/10/07.

It is a bit troubling at tonight's close to see the VERY LOW RISK, yet VERY LOW POTENTIAL RETURN of the 13-week Treasury YIELD see its BIGGEST single day move since the stock market crash of 1987.

With one eye focused on the VERY short-term 13-week Treasury Yield, I think equity traders will also want to keep another eye on the 5-year Treasury Yield ($FVX.X), which did show some "stability" today.

5-year Treasury Yield ($FVX.X) - Daily Intervals

One can only imagine what some Treasury bond mavens are thinking. In early June (see 06/09/07 Market Wrap), Pimco's Bill Gross turned bearish Treasuries, and market participants responded with aggressive selling that had the 5-year yield ($FVX.X) surging as high as 5.241% by June 13.

Bill Gross knows a lot more about economics and bond market interactions than I do, but I've got to think that the recent trade in the Treasury market has Mr. Gross scratching his head.

But just as I've been following "weakness" from the Russell 2000 Index ($RUT.X) leading to some weakness in the SPX, then OEX, NDX and INDU, we should be on the alert for a LOWER 13-week yield ($IRX.X) leading to further BUYING in the 2-year and 5-year Treasury, which could have its yield ($FVX.X) falling further lower.

Russell 2000 Index ($RUT.X) - Daily Intervals

Thursday afternoon, I alerted iShare Russell 2000 Sep $78 Put holders to close out their put options after the IWM itself traded near my $73 target at $73.24, when the IWM began rebounding further at $73.82.

In this Monday's Market Wrap, I show a "different" retracement, which also marks the RANGE from the recent 7/13/07 high to Thursday's low (just like the 13-week Yield and 5-year Yield).

But NOTICE that the now 50% retracement of 796.24, is VERY SIMILAR to last Monday's Market Wrap chart, and its "BLUE" retracement.

Here's the RUT.X chart from LAST MONDAY's Market Wrap.

Russell 2000 Index ($RUT.X) - From 08/13/07 Market Wrap

As I study/observe the 13-week Treasury Yield, then the 5-year Treasury Yield, and the previously analyzed WEAKEST RUT.X, I can only surmise that BUYERS of the small cap (RUT.X) (bearish shorts covering, or new bulls) have yet to show enough conviction to have the RUT.X close much above 797.

It is somewhat encouraging that buyers in the RUT.X at least perceived some type of RISK/REWARD turning more in the buyers favor from Thursday's intra-day low, but I would have to think that unless we see some type of reversal in either the 13-week Treasury Yield, or 5-year Treasury Yield to the UPSIDE, the WEAKER RUT.X is going to have trouble closing much above this 797 level.

But there is one bit of NEWS that I think has gone vastly unnoticed by the popular media, and that news broke late Friday afternoon.

Jim Brown noted it in this weekend's Market Wrap, when House Financial Services Committee Chairman Barney Frank, D-Mass., urged the Senate to pass legislation that would allow Fannie Mae (NYSE:FNM) $67.50 +0.37% and Freddie Mac (NYSE:FRE) $63.53 -0.26% to purchase more expensive mortgages than a bill Mr. Frank steered through the House earlier this year permitted.

In essence, it would appear the Mr. Frank is conceding to Treasury Secretary Paulson's warnings that over regulation in the credit markets could be harmful.

As "this story unfolds," it becomes somewhat apparent that the current credit crunch may indeed be a problem that has been placed at the feet of Fed officials, but in part due to the House Financial Services Committee having exacerbated the free flow of capital markets by restricting FNM's and FRE's ability to help finance larger mortgages.

"It now is clear we underestimated in the House bill how far we should raise the conforming loan limit, and the current crises in the mortgage market demonstrate we should raise it to a higher level." Frank said in a press statement. "I urge the Senate to make this a priority as part of GSE reform, because we now have the opportunity to help homeowners get access to needed credit by allowing Fannie Mae and Freddie Mac to play a larger role."

Here, I (Jeff Bailey) would have to see not only the FOMC working with the Treasury Department, but wonders never cease of if the U.S. Senate also begins to understand the intricacies of what can happen with lawmakers "over regulate" financial markets.

As it would relate to either the 13-week, or 5-year Yield, I would have to think that IF market participants see any type of Senate action being FAVORABLE to the credit markets, then we would see some type of SELLING in shorter-dated maturities, that appear to have LOW potential reward profiles.

Dow Industrials (INDU) - Daily Intervals

At tonight's close, the INDU is still down 6.4% from its recent all-time high of 14,022.

Compare that to the RUT.X, which is still down 8.05% from its recent all-time high.

With the Treasury bond market still saying "credit crunch," and a flight to safety, the RUT.X has rebounded 6.99% from Thursday's intra-day low.

The INDU has rebounded a more modest 4.81%.

Still, my analysis of both the Treasury bond and major equity indices suggest that until the RUT.X can at least show us a close ABOVE 797, it remains most vulnerable to further weakness.

For now, I think the relatively LOW Treasury Yield REWARD, but firm buying in this "safe haven" says something about the perceived RISK in equities.

Bottom line in my opinion is that NARROW and BIG (INDU,OEX,NDX) should lead an advance, combined with SELLING in Treasuries, which would have their YIELDs rising.

As of tonight's close, I'm not seeing it, and remain rather cautious from a buyer of equities point of view.

I do think the Fed is on the right track and is NOT underestimating the "credit crunch." I think the Treasury Department has been sending the Senate the right words of caution in recent months.

I'm looking for the FOMC to sit tight for the next few sessions, monitor the shorter-dated Treasury yields to see if further "injections" are needed in order to allow for LIQUID capital markets.

I don't see that equity markets are illiquid, but they certainly appear focused on the debt (bond) markets.

Look for the Senate to make the GSE reform a priority. The sooner the better is what I think BULLISH equity traders/investors want to see.

The shorter-dated Treasury yields strongly suggest at a minimum that Friday's FOMC action wasn't enough, nor was the aggressive 08/10/07 repurchase.

I will be out of the office next Monday (08/27/07), but hope to return on 09/04/07.

Have a safe Labor Day holiday!

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