Five Year Reaches Weekly Upside Symmetrical Target of Previous Outlier Events Right on Time

Monday, November 26, 2007
John Bougearel

Five Year Reaches Weekly Upside Symmetrical Target of Previous Outlier Events Right on Time
Previous outlier events in the past ten years include LTCM and 911. In those previous instances, the 5 year note rallied 7.12 points in 23 weeks and 7.08 points in 24 weeks. The current evolving credit crisis has caused the five year to rally 7.11 points in 23 weeks to 11013 on Wednesday November 21st. The 911 peak was one tick higher at 11014.
 


   
On November 20th, Freddie Mac fell 29% on an earnings loss announcement that was accompanied with the warning that a dividend cut was possible to heal meet capital reserve requirements. On Wednesday November 21st, the following day and the day before thanksgiving, the 5 year set a short term high. During Thanksgiving week ending November 23rd, the US Asset Backed Paper market had shrunk 29% to under $838 billion from its August 8th peak at $1.18 trillion dollars.

As we begin the new week, the 5 year yield sits near 3.43%, more than 100bps below the fed funds rate of 4.5% signaling either the Fed is behind the curve or that the 5 year may have gotten a bit ahead of itself. Actually, it seems to me, to be a combination of both at play. The next possible rate cut at the December 11th meeting is still two weeks out.

And still more bad news continues to leak out of the financial markets with today’s announcement by HSBC to bailout its two SIV’s, placing $45billion of assets back onto its balance sheet to avoid a fire sale of bond holdings reports Bloomberg. In a forward looking statement HSBC said they believed “there is not likely to be a near term resolution of the funding problems faced by the SIV sector.”

In the long run, bond investors should recognize that this outlier event is far worse than LTCM, by sheer the order of its magnitude. LTCM’s bailout was I believe around $4.5 billion, while the current crisis Super SIV bailout may excced $80 billion. Total losses during LTCM I believe were contained to about $11 billion. Total loss estimates the financial sector will incur when the present fiasco is all said and done range from $250 billion to $400 billion.

To make matters worse, these opaque conduits, be they SIV’s, CDO’s, all lack transparency. They are by and large “marked to make believe” rather than “mark to market.” The so-called Level 2 and Level 3 models employed to price these conduit products are inadequate. With no way to accurately price these products, they remain highly illiquid. As a result, central banker monetary policies are essentially “pushing on a string.” Policies of central banker accommodation are not going to provide liquidity where it is most needed for this credit crisis. And that, in short is what sets this crisis so far apart from 911 and LTCM. Fed policies of accommodation in those instances did provide sufficient liquidity to stimulate the capital markets.

The bottom line is that somehow, the present flight to safety into the five year note probably has much further to go on the upside over the intermediate term as it braces for the looming softening in the US economy and the jobs market. And we can expect that the 5 year treasury will keep its bid on balance over the intermediate term until the next economic recovery gets underway. Not having even begun the downturn, no one as yet can determine when the recovery will be at hand. Still, over the very near term, the 5 year may find the upside quite limited on its first attempt through the mid 110 handle. 

John Bougearel

Event-Driven Investment Research

Director of Futures and Equity Research at Structural
Logic