The Financial Sector

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1 Brad Smith January 30, 2009 The Financial Sector Yield Curve The yield curve has maintained its steepness over the past sixth months and has continued to be depressed on both short and long ends. With the recent auction of over $100bn in notes the government has proven that in the current crisis of confidence the market will accept a negative real interest rate in the short run. The Federal Reserve has indicated that it is willing to intervene in the securities market. While foreign demand for US Government debt has been substantial despite even negative yields, should foreign demand wane, yields will rise and the Fed will be forced to extend quantitative easing to the longer end of the curve. The Treasury is expected to announce n the next week that it will reinstate the 7 year note after a 16 year hiatus in an effort to cover the $500bn borrowing requirement this quarter. As the Treasury has already saturated the market with short term securities, it is forced to move to costlier, longer term securities to meet the requirements of the stimulus bill and bank bailout. Nonetheless, with all yields under 4.0% the treasury is achieving financing relatively cheap compared to a year ago. The consensus forecast on Forecaster.org indicates that the 30 Year Bond should rise by midyear to The Ten Year Bond is expected to fall to 2.22% in February but rise to 3.1% by August of this year. On the short end, the Bills are expected to make a slower recovery as demand for risk free shorter term assets will rise as the potential for a turnaround waxes. The 3 month T Bill is expected to gradually climb from its current rate of.24 to a value of.40. Bank of America, however, predicts a faster recovery on the short end, resulting in a flattened yield curve by mid 2009.

2 Corporate Bond Spread The spread between Moody s Baa and Aaa bonds rose to 338 basis points in December, making it the largest difference in corporate bond spreads since the Great Depression. The spread on corporate bonds is a measure of the level of risk associated with a debt investment in US corporations. The threat of exposure to toxic assets has pushed investors to choose only the highest quality investment grade bond. As the economy continues to contract, consumer spending wanes and industries face fates similar to that of the auto industry, the spread on corporate bonds will maintain an elevated level throughout most of As a result, many investment grade corporate bonds offer extremely enticing returns relative to the equity market. Effective Federal Funds Rate The effective federal funds rate is the actual interbank loan rate charged and often differs slightly from the target rate set by the FOMC. The recent decrease of the target rate to between 0 and 25 basis points has lowered the effective rate to the unprecedented zero bound. With no indication that the Federal Reserve Open Market Committee will raise rates any time this year, Bank of America predicts that the Effective Rate will only reach.3% by the end of Should credit markets begin to de ice later in the year, the trillion dollar government outlays and unprecedented excess reserves within the banking system will certainly create inflationary pressure. The credit channel should be closely monitored to determine if a target rate hike is likely by the end of the year.

3 Ted Spread The TED Spread measures the difference between the 3 Month London Interbank Overnight Rate (LIBOR) and the equivalent risk free rate, the 3 Month Treasury Bill. As a result, it is utilized as a measure of credit health in the financial sector and can be looked at as the relative cost of capital for banks. The collapse of Lehman Bros. and AIG in September of 2008 pushed the spread to its highest level since the early 1980 s. While the spread peaked at 393 basis points, the Fed s intervention in the credit markets has helped LIBOR follow the downward trend of the treasury, contracting the spread to 1.8 at the end of LIBOR is expected to rise from its current value of 1.13 to a value of 1.32 in July of The Obama Administration s current proposal for a bad bank solution to the financial crisis should have a significant effect on LIBOR and therefore the TED Spread if markets perceive the plan as effective.

4 Commercial Paper The spread on 2 month versus 1 month nonfinancial commercial paper is another indicator of credit risk in the economy. Commercial paper is an unsecure short term promissory note issued by banks and firms in order to obtain liquidity. Since the notes are unsecured, the spread between rates are a good indication of the general credit worthiness of nonfinancial institutions. Over the course of 144 months the spread averaged just one basis point but fluctuated within a range of 87 basis points. The spread peaked at 67 basis points in September of 2008 due to the collapse of Lehman Brothers. The contagion effect of the Lehman collapse can be seen on the second chart where A2/P2 yields jump nearly 200 basis points in one month. The creation of the Federal Reserve s primary commercial paper facility has experienced initial success in the market by compressing spreads.

5 S&P 500 Index and P/E Ratio The S/P 500 index closed the week at a value of , indicating a drop in the index for the year and continuing the downward spiral that has defined the market since the start of The S&P P/E Ratio Index is an average of the price earnings ratio of all firms which comprise the S&P index. The average P/E ratio over the past 45 years is The P/E ratio peaked in 2004 at a value of 45 times earnings. The ratio fell to at the end of 2008 leading some analysts to believe that the market is currently undervalued. Forecasters at Forcaster.org have indicated that the S/P index will continue to fall until it hits a trough around 741 in June of Bank of Americas projection that GDP will decline by 2.4% in 2009 while corporate profits will continue their sharp contraction indicates that a bull market is a long way off.