Look Out! Here Comes The Bond Market!

Hello All:

Things are about to get very interesting. This has been floating around the blogosphere, and it now appears to be confirmed by The New York Times. The bond market has had enough of the Fannie/Freddie games.

I was first alerted to this today when Fast Money talked about how the credit spreads have now climbed close to the highs that we saw when Bear Stearns went bust in March. It looks like the bond vigalantes are back with a vengeance.

Here is the article from the Times:

"A year after financial tremors first shook Wall Street, a crucial artery of modern money management remains broken. And until that conduit is fixed or replaced, analysts say borrowers will see interest rates continue to rise even as availability worsens for home mortgages, student loans, auto loans and commercial mortgages. The conduit, the market for securitization, through which mortgages and other debts are packaged and sold as securities, has become sclerotic and almost totally dependent on government support. The problems, intensified by bond investors who have grown leery of these instruments, have been a drag on the economy and have persisted despite the exercise of extraordinary regulatory powers by policy makers.

Bond investors first stopped buying private home mortgage deals, then shunned commercial mortgages. Now, they are becoming wary of credit card debts and auto loans. In the first half, private securitizations reached just $131 billion, down sharply from $1 trillion in the same period last year, according to data compiled by Thomson Reuters.

Some analysts say investors are acting like the “bond vigilantes” of the 1980s and early 1990s. Those traders drove a surge in interest rates because they feared inflation and a mounting federal budget deficit. Their actions helped slow the economy and forced policy makers in Washington to rein in spending and raise taxes, at least for a time.

“The bond vigilantes took law and order in their own hands and pushed yields up, which would slow down the economy and bring down inflation,” said Edward E. Yardeni, an investment strategist who is credited with coining the term. “This time the bond credit vigilantes are refusing to go into the saloon and start drinking what Wall Street’s financial engineers are mixing.”

Money market funds, the short-term cash alternatives, grew to $2.9 trillion in June, up from $2.1 trillion a year ago, according to Crane Data. Those funds, in turn, have more than tripled their holdings of Treasuries and other government debt while reducing the share of their portfolios invested in somewhat riskier commercial paper and corporate notes.

The pullback is compounded by a continued rise in interest rates despite the Fed’s efforts to grease the wheels of finance by gradually slashing its benchmark rate to 2 percent, down from 5.25 percent last August. The average interest rate on a 30-year fixed mortgage climbed to 6.7 percent last week, from 5.89 percent in the spring.

“It appears that every time we peel away this onion, there is another layer,” said Curtis D. Ishii, the senior investment officer for fixed income at Calpers, the large California pension fund. He added that investors were starting to realize that the pain in the credit market would persist for some time."

Final Take:

Take this very seriously guys. The fear in the credit markets is back up to its March highs.

As you can see above, money market inflows rose $800 billion from $2.1 trillion up to $2.9 trillion in June versus this period last year. The money markets took this cash and put 75% of it in treasuries. You know the saying "follow the money"? This situation is no different.

The market is running out of Wall St. and heading into treasuries for cover! No one wants any part of the mortgage slop that Fannie/Freddie has put together. The bond market has had enough of Wall St.'s games and the jig is up folks.

Whats different about the current scare versus the March Bear Stearns blowup is the Fed is out of bullets. They are helpless to stop this correction because its the bond market that is taking rates higher. The Fed can't slash bond market rates! Money gets more expensive when fear and losses grip the street.

Bottom Line:

Its become pretty clear that the bond market doesn't buy into the Fed bailout of Fannie/Freddie. The fact that the bond market wants no part of the GSE's paper means that they are calling out the Fed on their guarantee that they will back the $5 trillion in Fannie/Freddie paper. This is a startling development.

If the bond market did buy into the Fed backing of the two GSE's, than they would be buying this mortgage paper hand over fist because they know its guaranteed by the government. Spreads would have narrowed significantly if the bond market bought it. Instead we are back to the highs of March! Mortgage rates now sit close to 7%!

This is a very interesting development and one that I did not expect. If the bond market continues to push rates higher than its lights out for the housing market and all of the garbage paper that sits on Wall St's books.

Be very very afraid folks. This isn't going to be pretty.