Monday, February 2, 2009

Agency spreads on the mend

This chart illustrates how significantly agency spreads (the difference between the yield on FNMA debentures versus the yield on Treasury bonds of comparable maturity) have come down since they peaked last Nov. 21st (which not coincidentally was the low point for the stock market). As with other spreads, they aren't yet back to "normal" but they sure have made a lot of progress since the Ugly Days.

This spread reflects the degree to which investors distrust the creditworthiness of FNMA. A spread of zero would mean that investors viewed FNMA debt to be as safe as Treasury debt. When spreads peaked in November, investors feared that Fannie and Freddie would go out of business and the U.S. government would fail to honor its implicit guarantee of their bonds. This would have been catastrophic for global financial markets, since foreign governments and institutions held significant amounts of Agency debt.

This also underscores the nature of the current crisis, as being one of a crisis of confidence more than anything else. Financial market liquidity collapsed as investors feared widespread bankruptcies. Interbank lending and securitization markets ground to a halt as no one was willing to take on counterparty risk. Equity values collapsed as investors feared massive losses and paralyzed economic activity worldwide. Viewing the destruction of wealth on a massive scale, consumers with discretionary income cut back sharply on their spending. That in turn caused inventories to pile up, and businesses to lay off workers. It all added up to a sudden slump in economic activity everywhere.

Further compounding the problem, governments panicked and ill-considered bailout measures were quickly adopted. More recently, the Obama administration is trying to push through a massive so-called stimulus bill that has had only one day's worth of debate in Congress. We hear ominous things like "Buy American" that could escalate into a global trade war. It all strikes fear into the heart of investors everywhere, since it opens a Pandora's Box of unintended consequences, and a lasting expansion of the role of government. More government intervention, in turn, means less efficient private markets and a reduction in future living standards

I've been wondering why the equity market has not yet taken its cue from the significant improvement in swap spreads, agency spreads, and volatility. The "stimulus" bill may well be the answer.


mmf said...


your analysis and commentary is always intelligent and constructive. It's usually the first investment blog I vist each day.

One thing that seems to be getting worse though is LIBOR where it is inching up again - any thoughts on this? This is clearly a negative.

Scott Grannis said...

Libor is inching up, as you note, but T-bill yields have been inching up also, with the result that the TED spread has been relatively flat for the past three weeks.

Meanwhile, rising yields on short-term Treasuries are a positive sign that economic activity is picking up and risk aversion is declining.

I would also note that Libor yields sometimes rise because the market is anticipating an increase in short-term yields in general. Again, that would be a positive sign at this juncture, not a negative.

steven said...

Hi Scott,

I was wondering what your opinion was on the relationship between the S&P 500 and Gold. If we believe confidence in the market is beginning to strengthen therefore increasing the likelihood of a higher s&p 500 would gold go down?

Do you have any charts that show this relationship


The Lab-Rat said...

Deflation fears subsiding?

Scott Grannis said...

It's nice to see that a Google search reveals the same thing: deflation queries are indeed subsiding!

Scott Grannis said...

steven: I tried but the chart doesn't tell me much. The relationship between gold and equities is complex and ever-changing. Gold and equities both fell as the market collapsed in October, but since then gold has soared and equities have been flat.

Rising gold is a sign of rising inflation, I believe. Rising inflation has not been good for stocks, historically. It would therefore make sense that gold should fall if and when stocks truly recover. But I would be shy about making that bet.