Credit Recession Drives 10 Year Yields Down to Previous Outlier Lows

Submitted By John Bougearel

As noted in earlier reports, when an outlier event has occurred in the past ten years causing investors to seek the safe haven status of treasuries, the first thing the 10 year does is trade down to 4.10%. We have recently reached 4.13% as of last week. This is what happened during the LTCM crisis (totaling about a $4Billion bailout if memory serves) and the September 11 terrorist attack on the WTC.

The problem is that the credit recession has always been much larger in scope than LTCM. This credit recession is already requiring at least an $80 billion bailout of the SIV’s by the US Treasury, and at least another quarter to a half billion in writedowns according to Royal Bank’s chief strategist Bob Janjuah. And it still hasn’t gone away. This suggests to me that all the 10 year yield has done thus far is reach the upper support zone near 4.10%. But, before it is all over, 10 year yields will be much lower than where they are now.

Credit Recession Drives 10 Year Yields Down to Previous Outlier Lows

In fact, if I may suggest, the decline in yields off the October 2007 highs at 4.72% reminds me very much of the decline off the August 2003 highs at 4.67% for the following reasons. First, both rallies were relief rallies. In August 2003, there was great relief manufacturing activity had measurably picked up and that the deflationary scare had been defused. The rally into Oct 2007 began in September when it became a virtually certainty that the Fed was going to cut rates on September 18 to save the financial markets from a liquidity crisis.

The problem in August 2003 it was soon discovered is that what we on our hands was a “jobless recovery” according to the lagging and skewed BLS statistics, so 10 year yields plunged to 3.65% until the lagging BLS figures began to show a sudden surge in job creation in April 2004. Likewise, the financial markets are beginning to discover in 2007 that the Fed rate cuts are not going to necessarily provide the needed liquidity for the financial system. Why, because rate cuts are akin to “pushing on a string” in this environment. The problems in the credit markets is one of transparency, and an inability to price the products they have bundled. Bob Janjuah quipped that the products causing the credit turmoil are priced at “mark to make believe” rather than mark to market. In a mark to make believe world, what the Fed does with short term rates will have little effect in the areas where it is most needed.

It is interesting to note that the decline in 10 Year yields during the jobless recovery phase between August 2003 and the spring of 2004 continued until there was a secondary economic indication that the US economic recovery was legitimate. In short, the market required to see evidence of job creation to substantiate that the economy was indeed growing again.

When you think about it, the US economy is nowhere near reaching a spring 2004 inflection point, where the markets knew with a certainty that the economy was healthy and growing again. Hanging over our financial markets today is a looming slowdown in the economy which hasn’t even materialized yet (Q3 07 GDP stands at 3.9% before revisions), and a further slowdown in job creation which has which has only now begun to weaken in 2007. Depending on how badly things deteriorate when the looming economic slowdown arrives, this could take a few years to unwind rather than just a few quarters. As Deutsche Bank’s Investment Officer Benjamin Pace put it, “we had fooled ourselves a bit thinking that the third quarter was going to be the proverbial kitchen sink quarter where you got all the loan losses.”

Bottom line is this, don’t be surprised to see 10 year yields fall to the lower support zone around 3.55%-3.65% before all is said and done. In terms of cushioning the US economy from its looming weakness, the ten year treasury probably still has a lot of work ahead of it. As Stephanie Pomboy stated a few years back “We Can’t Handle Higher Rates” - at least not yet.