Something is afoot. The ramifications of this "something" portend to be significant, although what they will be, indeed, what this "something" actually IS, remains unclear.
In previous articles, I have suggested that there is a bubble of sorts in "bearish trades." I have cited spreads in the credit default market that appear elevated beyond fundamentals, and historic put/call spreads. I have cited abnormal volatility as measured by the VIX. As postulated, credit default spreads narrowed somewhat last week. Options spreads have declined, the TED spread is dropping, and as anticipated, the VIX has fallen off a cliff. Meanwhile, mortgage rates have plunged to some of the lowest levels in history, and LIBOR has dropped to its lowest level since June 2004. Taken as a whole, each of the foregoing developments would seem to suggest that the pile of liquidity that various central banks have doused the capital markets with has begun to flow towards borrowers and other end users, and that risk aversion has abated somewhat. This is not surprising because when money is cheap, using it to buy risky stuff is more palatable. This may perhaps explain why the price of equities has bounced up a little wee bit.
It is unclear whether this rosy assessment is illusory, because below the surface, something else, something that is potentially much, much bigger started to happen in the middle of November – quite a bit before the Federal Reserve slashed interest rates to about zero. The value of the dollar, as measured against a basket of other currencies, dropped by nearly 11% in just a month. That's… well…. stunning. But about what you'd expect given the low yield on US assets.
But here's where it gets weird. Over the same time frame, the price of ten year United States Treasuries rallied nearly 100%. And….uhhh……. that's a lot. A really, really, really, unusual kind of "a lot." When investors feast on Treasuries, that are denominated in dollars, demand for dollars is typically rather strong, for which reason the price of the dollar generally goes up relative to other currencies. Not this time around. Why?
And another important statistical correlation seems to have been tossed out the window over the last month. The price of a U.S. Treasury almost precisely reflects the level of revulsion investors feel towards risk. Over the exact time frame during which U.S. Treasuries have staged an unheard of 100% rally, the VIX has collapsed, suggesting, among other things, lower expected volatility and risk aversion ahead. Simultaneously, most major equities indexes have bounced off their lows of the year and settled in nicely at their 50 day moving averages – again, suggesting somewhat less than chronic risk aversion prevails in the market place today. The VIX, as well as the equities markets, are basically saying risk appetite is increasing, while the marketplace for U.S. Treasuries is suggesting a killer asteroid is approaching the Earth. One or more of these markets is a lying liar. Which?
A simple explanation may just be that a gargantuan pile of wealth appears to come to roost in the market for Treasuries. In doing so, interest rates have dropped, which has given some lenders (including the Federal Reserve and, now, the U.S. Treasury itself) the flexibility to put higher risk loans and other assets onto the books, or to originate new lending. Again, it's easier to take risks with cheap money, of which ample piles are sloshing around the system. And when the demand for risk goes up, the VIX drops, and the price for placing "bearish trades" comes down significantly which, it appears, has started to happen. And people start to nibble at equities, too.
The price of the dollar, however, remains a wild card. Having fallen off an 11% cliff, the buck is positioned almost precisely at its long term, 200 day moving average. It would be surprising not to see a bit a bounce in the value of the dollar from here – rarely do assets drop straight down. Whether this bounce will prove fleeting or not, I cannot speculate.
And what it all means is shrouded in mystery. Mysteries, these days, tend to involve bodies in the closet more than gifts under the tree. Mystery, in 2008, is not, shall we say, a good thing. Particularly the ones that offer zero percent financing that seems just too good to be true.
Disclosure: none.
