Excerpts from SCM’s March 5 Morning Meeting
Source: SCM Advisors
March 5, 2007

It’s definitely been an interesting last few days as risk premiums are being ratcheted higher in quantum chunks. Treasurys are benefiting from the flight-to-quality and once again are retesting the yield lows of the last 12 months. Fed funds futures opened the day toying with a 50% probability of an ease at the June meeting and another 50% probability of a second ease by the October meeting. As a result, 2s/10s approached zero this morning, the flattest since early September.

The market is over-reacting. We continue to view 10-year yields as being in a trading range, and that yields much below the current 4.40% to 4.50% as not offering a great deal of value. Because we don’t expect the first Fed ease to occur until much later in the year (ex some kind of meltdown) there is scope for a bit more inversion before the curve steepens further.

Other markets definitely remain nervous. Volatility has been reintroduced to the global stock markets (VIX from a 10 handle to a 20 handle in 6 days), although it’s probably best to view the action as a technical correction back toward their 200-day moving averages, after an extended run without a meaningful pullback. It may take more time before a healthier level of fear is built back into the market, and for volatility to retreat a bit, but lower Treasury yields clearly act as a stabilizer.

Fingers are being pointed in a couple of directions. Many are blaming the shakeup on an unwinding of the vaunted yen carry trade. Given all the breathless coverage recently, all eyes were on the yen this morning as it blew through its 200-day moving average at 117 ½. This should not be confused as a replay of last April and May when the yen carry trade was the cause of market freakage. This time it’s the result, as the increase in volatility has triggered risk models (like VAR) to signal that assets must be sold down to reach targeted risk levels. As riskier assets are sold and borrowed yen positions repaid, markets for those assets fall while the yen goes up… all fairly orderly so far.

The other area prominently cited as the cause of market turmoil is all the fun and games going on in the subprime mortgage market, which the media has been hyperventilating over recently. Andy Chow mentioned this morning that we may be nearing an extreme in market psychology, and Gretchen Morgensen’s NYT article this weekend could certainly mark such an outcome. While we expect housing to remain an economic headwind for the rest of the year, we don’t envision the full-blown financial and economic crisis scenario that’s been making the rounds.