Crude Breaks Support
By Colin Twiggs
September 4, 2008 9:00 a.m. ET (11:00 p.m. AET)
Crude oil broke through support at $110/barrel, warning of a primary trend reversal. The primary down-trend will be confirmed if the key psychological level of $100 is penetrated.
A recession in both the Chinese and US economies could lead to crude testing support at the 2007 low of $50/barrel. But China has been reporting double-digit growth in GDP and it would take a substantial drop in exports to cause a recession.
The Dow is consolidating between 11300 and 11800, accompanied by declining volume. Upward breakout would signal continuation of the secondary rally. We remain in a bear market, however, and downward breakout is more likely, warning of a test of 10000 — confirmed if 11000 is penetrated.
Ten-year treasury yields broke through support at 3.80 percent, signaling a test of support at 3.30 percent. The flight from mortage-backed securities, because of the uncertainty surrounding GSEs Fannie Mae and Freddie Mac, is driving treasury yields down. Yield differentials (with 13-week treasury bills), on the other hand, remain at a healthy 2.0 percent.
The spread between the fed funds rate and 3-month T-bills is close to zero, but it is clear from falling treasury yields and wide Libor spreads that market tensions remain high.
Compare the yield on 3-month T-bills to 3-month LIBOR, the offshore inter-bank rate which is less prone to Fed manipulation. Banks are demanding a premium of more than 1 percent above the T-bill yield — a long way from the 25 basis points enjoyed in early 2007.
The falling spread between 10-year treasurys and the equivalent TIPS rate reflects the flight from mortgage-backed securities into more secure treasurys, rather than declining inflation expectations.
The spread between asset-backed commercial paper and the fed funds target rate (2 percent) jumped sharply — increasing pressure on institutions reliant on wholesale funding.
Total commercial paper in issue is expected to decline further.
Corporate bond spreads remain high in anticipation of rising defaults.
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Mortgage spreads remain high as lenders attempt to re-build their balance sheets. Rising mortgage rates have the potential to further suppress housing demand and prolong the down-turn.
Credit growth continues to fall, restricting consumption and new investment.
It will be some time (years rather than months) before the financial sector can withstand a reduction in the record levels of Fed support for the financial system. The chart below does not even include the $29 billion Bear Stearns bailout.
The second quarter profile of FDIC institutions reveals some disturbing trends:
|June 2008||June 2007||June 2006|
|Average Return on Assets (QTR) %||0.15||1.21||1.34|
|Net Charge-Off Rate (QTR) %||1.32||0.49||0.35|
|Noncurrent Loan Rate %||2.04||0.91||0.70|
|Coverage Ratio %||89||120||159|
Profit margins (ROA) have fallen to almost zero as charge-off rates rise. Non-current loans (at least 90 days past due or not accruing interest) have almost trebled. And loss reserves declined to the point that they no longer cover non-current loans, with a coverage ratio of 89%. Further falls in housing prices are likely to result in more bank failures.
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