Crude Breaks Support

By Colin Twiggs
September 4, 2008 9:00 a.m. ET (11:00 p.m. AET)

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Market Overview

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.

West Texas Intermediate Crude

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.

Dow Jones Industrial Average

Treasury Yields

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.

10 year treasury yields and yield differential with 3 month treasury bills

Market Uncertainty

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.

The Fear Index: fed funds rate minus 3-month treasury bills

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.

Libor Spreads

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.

10 year treasury yields minus 10 year TIPS

Financial Markets — Commercial Paper

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.

commercial paper rates compared to federal funds rate and treasury bills

Total commercial paper in issue is expected to decline further.

commercial paper total balances

Corporate Bonds

Corporate bond spreads remain high in anticipation of rising defaults.

corporate bond spreads


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.

30 Year Fixed Mortgage Rates Compared to Treasuries

Bank Credit

Credit growth continues to fall, restricting consumption and new investment.

bank credit growth

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.

reserves of depository institutions

The second quarter profile of FDIC institutions reveals some disturbing trends:

June 2008June 2007June 2006
Average Return on Assets (QTR) %
Net Charge-Off Rate (QTR) %1.320.490.35
Noncurrent Loan Rate %2.040.910.70
Coverage Ratio %89120159

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.

A leader is a dealer in hope.

~ Napoleon Bonaparte

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