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Driving Interest Rates -- September 2008: High Volatility Due to Extraordinary Government Measures Taken to Support the Credit Market September was a particularly volatile month for the financial markets. The average daily price change for the benchmark 10-Year Treasury Note was 25/32 (plus or minus). Yet, while the note's yield moved through a 46 basis point range during the month, it finished just 1 basis point above were it began. The Labor Day holiday kept some bond traders out of the market in the first week of the month and light volumes increased volatility. An early, technical bounce in stocks, aided by a sharp drop in oil futures, eventually faded and turned into a loss as the manufacturing index for August came in lower Treasuries fell back again on the first Friday of the month despite a weak employment report for August. The report showed more payroll losses than expected and the unemployment rate jumped to its highest level since September of 2003. However, the previous day's stock losses cushioned the blow there and the market held steady. This took support away from Treasuries and they fell sharply. The wild gyrations continued the next week. Treasuries began Monday the 8th deep in the red in response to Sunday's news that the secondary mortgage marketing agencies, Fannie Mae and Freddie Mac, had been placed under government control. Freddie Mac, originally named the Federal Home Loan Mortgage Corporation, and Fannie Mae, originally the Federal National Mortgage Association, were hybrid companies, established by the government but run as private corporations known as government sponsored enterprises (GSEs). The agencies purchase loans from approved lending institutions, create mortgage backed securities, and sell the securities in the financial markets. Servicing of the loans is handled by the primary lending institutions or servicing companies. A portion of the securities are held by the agencies themselves. They also issue their own corporate bonds to raise capital. In the last couple of years, the collapse of the securities sector backed by high-risk mortgages has weakened the companies and clouded confidence in their ability to continue functioning effectively. The worries have persisted despite the agencies' credit lines with the Treasury and other sources of capital including the Federal Reserve's discount window. The situation ultimately led to the announcement by Treasury Secretary Henry Paulson that the companies had been taken over and were now under the operational control of the Federal Housing Finance Agency (FHFA). With firmer backing for the agency debt securities, the safety allure of Treasuries diminished. In addition, traders were concerned that more government debt securities (Treasuries) would have to be issued to shore up the capital support for the mortgage agencies. But the takeover also spurred a round of mortgage-related hedging, which in combination with some bargain hunting following Friday's losses, allowed the market to shed its morning losses on Monday and finish the day with modest gains. The high volatility fed on itself as stock traders took profits on Tuesday the 9th. Reconsideration of the takeover news also had an effect. The magnitude of the government action underscored the severity of the trouble facing the credit market. Some traders were simply unnerved by the change in risk dependencies in the credit network and moved toward Treasuries as a safe haven. The shift out of equities and the heightened credit concerns gave firm boost to Treasuries. Stocks held steady on Wednesday the 10th and Treasuries gave back some of their gains on profit-taking. The sell-off continued through the rest of the week as stocks found support from falling oil prices and word that Lehman Brothers might be bought by Bank of America. New supply in the form of a 10-Year Note reopening also weighed on the bond market, though the additional issue was well received. The losses for bonds that week came despite some supportive news. The report on retail sales for August showed a larger than expected contraction and August's Producer Price Index, a gauge of inflation at the wholesale sector, showed the first contraction in eight months and the largest contraction since October of 2006. Weak economic news and low inflation indicators promote lower interest rates and that increases the perceived present value of bonds. The following Monday brought new market convulsions. Stocks dove and Treasuries soared. The rumored takeover of Lehman Brothers failed to materialize and the company filed for bankruptcy -- the largest in history. In addition, Bank of America agreed to acquire Merrill Lynch while insurance giant, American International Group (AIG), announced that it was exploring ways of raising capital and reducing its liabilities. The inflation news of the day was positive: the Consumer Price Index (CPI), the inflation gauge at the retail level, declined in August for the first time in twenty-two months. Bonds fell back the next day. Some of the movement was a reflection of profit-taking and some on disappointment that the Fed did not make an interest rate cut at their monetary policy meeting. The policy statement noted that there were challenges to the economy and the financial markets, but the committee felt actions already taken should promote growth and market liquidity. Bonds were also pressured by rumors that the Federal Reserve was considering a bailout of AIG. The bailout rumor turned out to be true. The Federal Reserve said it planned to lend as much as $85 billion to the company. But stocks had a negative reaction to the news since it was another example of how the credit market was crumbling. Stocks fell sharply but Treasuries only made slight gains. More credit market news had a different effect the next day since the project was so massive. A number of major central banks from around the world agreed to inject money into their monetary systems in order to maintain liquidity in the credit markets. The participating institutions were the U.S. Federal Reserve, the European Central Bank, the Bank of Canada, the Bank of England, the Swiss National Bank, and the Bank of Japan. The agreement was for overall support of up to $180 billion. A number of government actions were announced the following day. The Securities and Exchange Commission (SEC) ramped up its efforts to block downside pressure on the financial sector of the stock market by temporarily banning the short-selling of 799 financial stocks. The Federal Reserve announced that it would begin purchasing agency debt from primary securities dealers in its open market operations. And the Treasury announced that it would temporarily back U.S. money market funds from eligible funds that pay to participate in the guaranty program. Moreover, a report that the government was considering the establishment of a repository for bad debt also had a strong influence on the markets. In response to all of this news, Treasuries sold off sharply for the remaining two days of the week while the stock market made strong gains. On the following Monday (22nd), the major financial market news was that the Federal Reserve allowed investment banks Goldman Sachs and Morgan Stanley to become bank holding companies which can establish commercial banks in order to bolster their capital base. Investment banks trade securities in the capital markets while commercial banks can receive deposits. Despite the news, stocks pulled back sharply on a round of profit-taking following the hefty gains made in the previous two sessions. The stock market continued to decline on the 23rd and the bond market marked time, falling slightly on the 22nd and rising slightly on the 23rd. Both stocks and bonds were little changed on Wednesday the 24th. Despite the backup in stocks, Treasuries were under supply pressure from the monthly issues of 2- and 5-Year Notes. The offerings drew lukewarm demand but the 2-year offer size was a record high and the 5-year offering was the largest in over five years. Stocks made respectable gains on the last two days of the week (25th and 26th) as administration officials and congressional leaders worked on a bailout package for the financial sector. An agreement in principle was reached on Thursday and broke down on Friday. Most observers were confident, however, that some package would be put together and enacted. Stocks even held up under the news that the Federal Deposit Insurance Corporation seized Washington Mutual, making for the largest bank failure in U.S. history. The bank's assets were sold to JPMorgan Chase. A bailout package was hammered out over the weekend and presented to the House of Representatives on Monday the 29th. Even before the vote was taken, stock traders had been unnerved by news that the Federal Deposit Insurance Corporation (FDIC) announced that Citigroup would acquire the banking operations of Wachovia, the nation's fourth largest bank. In addition, over the weekend, Dutch-Belgian bank and insurance provider, Fortis, had to be bailed out by the Netherlands, Belgium, and Luxembourg. English mortgage lending giant, Bradford and Bingley was nationalized by the British government. And Germany bailed out Hypo Real Estate Holding. The final straw for stocks was that the bailout package was voted down. The market plummeted with the Dow posting an all-time high point loss for a single day. Treasuries rallied. But stocks bounced on the last day of the month and Treasuries lost most of their previous day's gains. Housing : The housing data released in September was bearish. The report on construction spending for July revealed a sixteenth consecutive decline in the seasonally adjusted, annualized spending rate for the residential sector and the twenty-seventh in the last twenty-eight months. Moreover, July's rate was the lowest since May of 2001. The report on housing starts for August said that the rate of new construction fell to its lowest level since January of 1991. In addition, the rate of building permit issuance -- a gauge of near-term starts -- fell to its lowest level since February of 1991. Home sales figures also painted a gloomy picture. The rates of both existing and new home sales declined in August with the drop in new home sales leaving the pace at its lowest level since January of 1991. |
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than expected and July's report on construction spending indicated ongoing contractions. The turnaround in stocks helped lift Treasuries and they made substantial gains. They fell back somewhat the next day but rallied the following day as stocks experienced a sharp sell off on weak sales reports from auto dealers and several major retailers. 