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.