Deadly Diversion

Another day in the bond market like yesterday, and the Fed will cut rates on Friday. Short-term interest rates and long-term interest rates are moving in opposite directions. When that happens, it's bad news.

We're tracking the divergence through yield indexes that trade at the CBOE. Yields move in the opposite direction to bonds. Right now, the three long-term yield indexes we follow -- 5-Year (FVX), 10-Year (TNX) & 30-Year (TYX) -- are more than three standard deviations below their respective 90-day mean prices. They're more than two standard deviations below their 10-day mean values.

But the short-term yield index -- 13-Week (IRX) -- is only one standard deviation below its 90-day mean. On a 10-day basis, IRX has been around three standard deviations above its mean price for the past couple days. Banks will not lend to each other over the short term, hence the divergence.

If the black-box hedge funds couldn't deal with CDOs, they'll never be able to withstand this incredible divergence for long.

We thought it was laughable that the Fed said it will look to "anecdotal" evidence of tight credit in the future. LIBOR rates are at seven-year highs, and that's what most scalable loans use as a reset touchstone.

So, either the Fed acts soon, or the stock market takes a serious hit. If they're smart, the Fed will try to help this thing settle down slowly by instituting a series of rate cuts. We think they are smart, they just needed to be reminded of it by the market.