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Monday, August 20, 2007 2:59 PM


Flight to Safety


MSNBC is reporting Flight to safety hits yield on Treasury bills.

Money market investors staged a dramatic flight to safety, knocking down yields on short-term US government debt in early US trading on Monday, as top Treasury and Federal Reserve officials continued behind-the-scenes efforts to shore up confidence in the credit market.

The yield on the one-month Treasury bill fell 160 basis points to 1.34 per cent in early trading. The yield on three-month Treasury bills tumbled to 2.51 per cent, 123 basis points below Friday's close – a sharper fall than during the October 1987 stock market crash.

The scramble to obtain government paper at any price is a sign of extreme risk aversion, and suggests the Fed's actions have yet to stabilise sentiment in the credit markets.

While conditions elsewhere in the credit markets remained broadly stable on Monday, the big shift in Treasury bill yields encouraged speculation that the Fed would have to cut interest rates soon.

Analysts said the plunge was driven by shifts in asset allocation by the large money market funds, which hold $2,700bn in assets. They said "enhanced" money market funds – which normally hold some non-government securities in their portfolios to increase their returns – were facing redemption pressure from investors and were desperately seeking safe assets.

At the same time, investors are piling into traditional money market funds – which invest only in government paper – as investors dump riskier assets.

"We had clients asking to be pulled out of money market funds and wanting to get into Treasuries,"' said Henley Smith, fixed-income manager at Castleton Partners.

Separately, it emerged that Deutsche Bank had taken advantage of new loan terms offered by the Fed to ease the credit squeeze.

People close to the situation said Deutsche's decision to borrow from the "discount window" – a line of direct loans from the Fed to banks – came on Friday, hours after the Fed surprised the market with its decision to lower the rate on these loans to 5.75 per cent from 6.25 per cent to stimulate banks' willingness to lend.

Deutsche Bank declined to comment but people close to the situation said its decision to tap the window was taken to show support for the Fed's move to combat the credit turmoil.
A Show of Support?

And adding to the Fed's charade of cutting the discount rate is a claim “by people close to the situation” that Deutsche Bank was showing support for the Fed, supposedly by borrowing cash it does not need. No one borrows money at the discount rate to show support for the Fed. The statement is simply preposterous.

What's pushing down short term yields is a basic flight to quality. Everyone is abandoning non-traditional money market funds, in mass. This means that speculative credit demand has come to a standstill. It's also a loud and clear recession signal. Given that T-bills are the next best thing to cash, this is simply yet another variation of a Mad Dash For Cash.

The Yield Curve

The yield curve is indeed signaling something and that something begins with "R".



The above curve is thanks to Bloomberg and is as of 2007-08-20.
The yield on the 3 month T-Bill is currently sitting at 2.96 and the 6 month T-Bill is 3.94.That's lot of rate cuts priced in.

The 3 month T-bill rate was at 2.4% at the intra-day low. But not shown on the chart is a stunning drop on the 1 month rate to 1.34%. What's happened with the T-bill over the past few trading days is really unprecedented. It's a sign that this crisis is much worse than the stock market seems to think.

Any Money Market Fund heavily invested in mortgage backed securities is going to come to regret it as are "Government Bond Funds" of all sorts. Far and away, most government bond funds are heavily invested in agency paper (Fannie Mae garbage).

Anyone in a "government bond fund" or small high yield money market fund would be well advised to find out before it's too late, just what those funds are invested in. Unfortunately, it may already be way too late for some invested in those funds.

The sad thing is that investors were not remotely paid for the risk. Returns over US treasuries were stunningly minimal. The flight to safety has barely started. Expect more fireworks soon.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

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