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What really Happened?

The fear of Fredie Mac (FRE) and Fannie Mae (FNM) might go under and seems never ending worries of financial system health created chaotic trading on Friday (7/11). On this very "scary" and almost panic market with VIX almost hit 30 intraday, one would fully expect to see the capital flow to the ultra safe US treasuries. However, on the contrary, across the curve, the treasuries tumbled as soon as the equity market opening bell rang, 10yr note fell 1-10/32 and yield shoot up from about 3.80% to close 4.00%, while the Freddie and Fannie bills and notes as well as fixed MBS were attracted quite some interests. For example, the spread of 2-yr agency note to treasury was tightened almost 20 bp from 71.4 bp on Thursday to 52.0 bp on Friday, while on 10 yr part curve, the spread was narrowed from 101.6 to 86.4. Freddie and Fannie CDS were also tightening but not widening. It is amazing to see the risk premium was declining when the risk of underlying companies seems at the highest and almost unthinkable if the market is "efficient."

The popular and convenient explanations for the tumble of treasuries and relative strong performance of agency debts were the possibilities (hope) of the government intervention and rescued both Freddie and Fannie to save the debt investors at the expense of existing equity investors. This sounds logical but can not explained by the fact the treasury sell-off was never stopping from the beginning of early morning, a far earlier than Reuters news story the Fed might open the discount window to both firms. Was the market telling us that the government is for sure going to step in for rescuing or something else? Could this possible that the market sentiment has hit the bottom and some of capitals rotate out of the most over-valued asset class, namely treasuries, back into equity market?

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