Another Glimmer of Hope: The Repo Market

Many indications of acute credit crisis remain, and the economic drag from a constricted credit market will remain for quite some time, but some credit markets are also giving some modest signs of crisis-alleviation. As we see a few signs like this, we're encouraged to (1) add slightly -- not significantly -- to our equity allocations (which remain underweight overall), (2) avoid being very overweight Treasuries after their tremendous rally, (3) be less likely to trim our municipal bond weighting, (4) comb for other attractive assets with low correlation with our portfolio.

From Bloomberg:

• The dollar isn't the only casualty of the Federal Reserve's rescue of seized-up credit markets. Bond traders are finding there is nothing special about Treasuries anymore, now that the Fed accepts substitutes for government securities as collateral -- having concluded it wasn't enough to reduce the benchmark interest rate for overnight bank loans six times since September.

  As recently as March 21, Treasuries were in such demand that traders were willing to lend cash at rates 2 percentage points less than the Fed's target for overnight loans if they could obtain the securities as collateral. Now, the gap is back in line with the 0.06 percentage point average in the 10 years prior to August, when subprime mortgage losses spread.

  The $6.3 trillion-a-day repurchase agreement, or repo, market is a barometer of sentiment because it's where firms finance trades. A narrowing of the spread between the so-called general-collateral and federal-funds rates may suggest declining demand for U.S. government debt. Treasuries have lost 0.8 percent on average since March 20, when the central bank expanded the type of debt it would take in return for the securities to include mortgage and commercial real estate bonds.

  ``It is an indication that the markets continue to lurch uneasily back toward normalcy,'' said Ward McCarthy, a principal at Stone & McCarthy Research Associates in Skillman, New Jersey, and a former chief financial economist at Merrill Lynch & Co. and senior economist at the Fed. ``The pressure in repo trading has finally begun to ease.''

But we're still a headline or two away from further cracks in markets. Our asset allocation moves still reflect our view of this risk.