Across the Curve

Some Thoughts For September 19 2008

Prices of Treasury coupon securities are, for the most part plummeting in response to the deus ex machina action by the Congress, the Administration and the Federal Reserve to confront the credit crisis with direct, forceful and radical action. As stitched together from various media reports, which I will link to later, the plan has three legs. The first leg is the SEC (whacko) proposal to ban short sales. The second leg is a purgative act which would establish a mechanism by which the government would purchase illiquid assets from banks. Finally, the Federal Reserve would back stop money funds establishing some sort of FDIC insurance for money funds.There are no specific details on any of this at 630AM New York time but details are expected some time today.

The interesting detail will be the cost. It will be enormous.

The proposal will certainly come with a host of regulations and restrictions which will radically alter the face of the financial business. The freewheeling trading style which has been in vogue over the last generation will slip off into history.

I love history and in the grand panorama of history I think that this proposal will mark a significant punctuation point. The high water mark of American liberalism and the New Deal era was the landslide election victory of Lyndon Johnson in 1964. At the time many thought that the two party system was dead and questioned the ability of the Republican Party to survive.

It turns out that the Republican Party and conservatism rose from the ashes of that ignominious defeat and both the party and the conservative idea have thrived and prospered for most of the last 44 years.

American history moves in cycles and I think that this imminent government action in the financial markets represents the end of that cycle and will usher in the beginning of a new cycle of active and interventionist government. In a sense, this is an act of political exorcism and the ghost of Barry Goldwater has been expelled from the living room.

Back to the bond market. There has been a rather dramatic shift in the yield curve in response to this move by the government. The yield on the benchmark 2 year note has jumped 26 basis points to 1.96 percent. Recall that at one point yesterday it traded at 1.35 percent. The yield on the 5 year note has climbed to 2.80 percent. It traded in the 2.30s yesterday. The yield on the 10 year note has climbed 9 basis points to 3.64 percent.

The price action in the Long Bond is inexplicable. It has edged higher by just 2 basis points to 4.21 percent.
This government action will require massive outlays of funds. It will not be a short term enterprise. Some of those funds will be raised out the curve, for sure.

The proposal will also bring questions about the dollar and the potential inflationary impact of this type of massive spending proposal. Against that background, it is difficult for me to understand why anyone would accept a 4.20 percent yield on a 30 year piece of paper.
The 2 year /10 year spread has narrowed to 168 basis points. Recall that following the Bank of New York Mellon announcement that one of its money funds had broken the buck that the spread gapped to 195 basis points.

Enough for now.