Where the market’s will go? - analysis

Analysis

Why the market’s positive reaction to the Fed’s rate cut could be short-lived?

The markets are crashing. It seems that no one can save them now. But wait a minute, what’s that up there in the sky? Is it a bird? Is it a plane? No - it’s a helicopter, actually. And the man at the controls, US Federal Reserve chief Ben Bernanke, clearly hopes that by flooding the US financial system with enough dollars, he can prevent the whole credit bubble from collapsing.
So can he succeed?

Fed chief Ben Bernanke once said that, if necessary, the Fed could prevent a recession by making the money printing presses run over time, then jumping into a helicopter and dropping free dollars across America. He was joking, of course. You don’t need a helicopter to distribute free money these days - electronic networks are far more reliable and there’s no danger of getting bundles of notes tangled up in the rotor blades while you’re hovering a few hundred metres over Detroit.Yes, the man who said that subprime was contained just a few short months ago has now clearly decided that this was a bit optimistic. The Fed therefore slashed a key US interest rate by half a point on Friday, leading to a massive bounce in equity markets.

Now let’s get this clear - the Fed didn’t cut the main interest rate, the one we read about all the time. The rate that it slashed was the discount rate. This is the rate at which banks can borrow directly from the Federal Reserve banks. The rate was 6.25% - now it’s 5.75%. Banks don’t normally like to borrow direct from the Fed. That’s because, in normal times, it’s more expensive than getting money elsewhere. That’s why the Fed is seen as a ‘lender of last resort‘. And if you’re resorting to your last resort, then that suggests your business is in trouble. So there’s a hefty stigma attached to doing business with the central bank.

The reason that the discount rate is higher than the key rate, is because you want to avoid creating ‘moral hazard’ - the idea that the Fed will always bail you out, regardless of how badly you run your business. At the same time, if the financial system collapses for some reason, and even good businesses can’t get credit, the Fed needs to be there to step in and keep things moving. So while the Fed will lend to banks directly, it does so at a penal rate, so that it’s always seen as a short-term solution, and not something that a badly-run bank can just dip into every time it runs into trouble. But now the Fed is positively encouraging banks to come forward and take advantage of its cut-price credit sale. Forget the stigma, it’s saying, You need this money. You can’t get it anywhere else. We’ll even take those mortgage-backed loans you can’t sell anywhere else from you as collateral. The markets thought this was great news. Traders see it as a prelude to a full-scale interest rate cut, and they may well be right.
But would that really be good news?

Apart from anything else, a rate cut would confirm that there really is a serious problem with the US economy. That’d be fine, except that the US economy is currently being propped up by foreigners. People have been piling into Treasury bonds as a safe haven in recent weeks. But once they realize that the Fed intends to inflate its way out of trouble, they won’t be as happy to hold onto them. And how cheerful are all those foreign investors going to be when they realize that the Fed is also bailing out banks by taking what the rest of the market views as toxic waste as collateral?

Bernard Connolly, global strategist at Banque AIG, has a fascinating column in this morning’s Telegraph (worth a look especially for his comments on Europe, which we won‘t delve into this morning: Subprime crisis is the edge of a financial hurricane). He rightly points out that the seeds for the current crisis were sown by Alan Greenspan keeping interest rates too low throughout his time as Fed chairman. He also reckons that Bernanke will need to slash rates, just as Greenspan did in 2001, to prevent the economy falling off the edge of a cliff.

But Greenspan postponed the current problems by swapping one asset bubble for another - the tech bubble became the housing bubble. What’s left to inflate? You could cut interest rates to 0% now, and US banks still wouldn’t lend money as carelessly as they have in recent years. ‘Ninja’ mortgage loans - to those with no income, no job and no assets - are a thing of history. This is what the Japanese found out a long time ago. Once your economy’s credit bubble has popped, no amount of sticking plaster will enable you to pump the bubble back up. And the more you try to fiddle with the financial system, the longer the pain of adjustment is drawn out.
As I suspect we’re going to find out.
Turning to the wider markets… (moneyweek.com)

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