Liquidity crisis continues with demand for Treasuries

There are often three levels of flight to quality based on the amount of market uncertainty. We may be at the highest level of uncertainty based on the current movement in cash yields.

Level one is when funds flow from higher risk assets to lower risk assets within the same asset class. This would be a shifting of funds from low grade to high grade bonds. This could be caused by relative pricing and views on the merits of subclasses with different credit quality. This could be a movement from high to lower beta stocks.

Level two flight to quality is a movement to Treasuries along the yield curve. Again this is a relative asset class allocation change. Duration risk is kept constant. It could mean an allocation from stocks to bonds. There is still a desire to hold risky assets but in a another form or another asset class.

Level three flight to quality is a dramatic movement to cash. Investors get rid of all risk and hold only the risk free asset. Yield curves especially for very short maturities become very steep. This will occur if there is maximum uncertainty or when there is the belief that no asset class is safe.

We are in a level three flight to quality. The movement is out of all risky assets and into the risk free asset. The change in rates for short-term instruments has been dramatic. Treasury bill rates have fallen off a cliff with little desire by investors to hold risk. We have little experience with these types of dramatic flows to quality but when markets move to extremes there is a greater chance that others will find level compelling.