Credit market worries push short-term Treasury yields to 50-year lows

Despite a bear-market relief rally in equities this past week, there was a continuing flight to safety and liquidity in the credit market. Both markets are unlikey to sustain the extremes of this week's trends. Given that the recession has not yet inflicted the bulk of its coming pain on consumer and business spending and consequently on earnings, the equity market uptrend is likely to prove temporary.

The Fed is virtually certain to be forced by the recession and credit crunch to ease further. That and ebbing inflation fears as the global recession takes hold will pull Treasury bond yields lower. But, the Thursday lows in Treasury 3-month bill yields, which were partly due to special factors, are likely to prove temporary.

There were a number forces at work behind the equity market rally this past week. Both Lehman Brothers and Goldman Sachs reported first quarter earnings that, while down more than 50% from a year earlier, were far better than feared. The market was reassured that these two institutions were not following Bear Stearns' path of failure and forced sale. That precipitated a relief rally in these two stocks that carried over into other financials and the general equity market. The Federal Reserve's agressive easing also played an important role. The three-quarter percentage point cut in the Federal funds rate to 2.25%, the implicit promise of more easing to come as needed, other forms of Fed credit support(including direct lending to nonbanks)and credit injections by the Europen Central Bank encouraged the equity market in the false belief that the worst was over. Indeed, many observers indicated that the equity market had put in its bottom and was now primed for a sustained rise. However, as the week ended there were signs of more problems ahead that will soon jeopardize the equity market rally.

Ominous developments included a prononced selloff in commodities. It was blamed on fears that a deepening recession would reduce global demands. While true enough eventually, it is currently premature for that to be the sole or even primary reason for the plunge in commodities. Rather, the commodity sellof is an indication that the deep losses in largely unmarketable subprime mortgage-related debt or other contracts is forcing financially stressed holders to liquidate assets that still have value. This is an example of a variation on Gresham's law that bad assets drive out good. It suggests more financial troubles have yet to come to light.

As if to underscore that point, CIT group, the largest US independent commercial finance lender, reported Thursday that its normal sources of funding had dried up in response to the credit crunch. As a result,the firm was drawing down its entire $7.3 billion back-up credit line. CIT's problems are far from unique. They also portend financing trouble for small and medium-sized firms heavily dependent on credit, especially on nonbank sources. But, banks have their own troubles, and their lending is also likely to continue contrained, despite Fed efforts to inject liquidity. Late in the week, Credit Suisse Group dashed the belief that banks are out of trouble with its announcemant that losses in March will produce a loss for the first quarter. Though this stemmed in part from inadequate write-downs of mortgage-related assets, there are other problems brewing. Regional builders, for example, with strained financial resources, are increasingly delinquent or in default on their loans, placing pressure in turn on their lenders, typically regional banks. It was problems such as these that led Fed Chairman Bernanke in recent testimony to warn of the likely step-up in failures of small banks.

On Thursday, short-term Treasury yields plunged to 50-year lows in response to the credit market squeeze, the Fed's easing, the sharp drop in commodity prices and especially uncertainties over possible adverse devlopments over a long holiday weekend. The bond equivalent yield on the 3-month Treasury bill ended the week at 0.514%(after falling as low as 0.3%),down from an already low 1.17% the week before. The 3-month Treasury bill yield is often seen as an indication of where the market thinks the funds rate is ultimately headed. I look for a return to a 1.0% Federal funds rate late this year or next. However, Thursday's low US bill yield level seems less a market indication that the Federal funds rate is headed for Japanese style levels than it is a temporary near panic drive for safety and an effort to preserve liquidity. Though it may seem hard to believe, that objective in the great depression of the 1930's was a major factor that led Treasury bill yields to actually fall below zero. The current situation is not that dire, though admittedly worse than widely recognized. The two-year Treasury note yield was 1.55%, while the 10-year reached 3.33%,down from 3.51% the previous Friday. But yields on lesser credits, even high grade debt, rose further last week as the quality yield spread between credit grades widened further, with the prospect of still more to come. This is a clear indication that the willingness to lend and invest has disapated despite Fed efforts to amelirate the credit crunch.

The credit crisis is deepening, and with it the risks to the economy. Though the yields on 10-year and longer maturity Treasuries are already near their previous cyclical lows and the lowest levels since the Eisenhower Presidency, expect still lower Treasury bond yields once the recession is in full swing and inflation concerns at least temporarily disappear. Only after the recession appears to have run its course and the danger of default lessens will the widening quality yield spreads be cyclically reversed.