The Week Ahead in the Capital Markets

May 12, 2008

“We are closer to the end of this problem than we are to the beginning.” – Treasury Secretary Paulson

I also made some optimistic comments several weeks ago, and paid the price. “You’re crazy – the worst part of the storm is yet to come,” said one friend. “Premature extrapolation!” said another. “Just wait until the baby boomers start to sell their homes. Then we’ll really feel the pain,” said one more.

AN INSIDER’S VIEW FROM THE CAPITAL MARKETS COOPERATIVE TRADING DESK:

“If some say we’re headed for better times, and others fear the worst is yet to come, where can we find an accurate measure of the market? I believe in the wisdom of the market crowd, and the crowd is telling us that while the peak of the crisis may be behind us, the level of risk is still very high and has increased in the past two months.

Evidence of this market sentiment abounds: swap spreads (the difference between LIBOR and Treasury yields) remain at twice the level they were a year ago; daily fed funds volatility is three times its level of a year ago (thanks to Dr. Giles at Columbia Univ for this tidbit); fed funds futures still show a bias towards easing; and the spread between mortgage and Treasury yields, while much narrower than two months ago, is historically wide at 2.45%.

Specifically regarding fed funds, the futures market does not expect any movement from the Fed in the near term. Futures contracts are essentially flat at 2.00% until early 2009. During the first half of 2009, however, the market expects the Fed to begin tightening, taking funds to 2.75% by early fall. Inflation is still a concern. Crude oil jumped 8.3% last week to $126 per barrel, and Barron’s reports that foreclosed houses