Equity sell off wreaks havoc on money markets

A global exodus from risky assets extended into a second day after Lehman filed for bankruptcy protection and Bank of America agreed to buy Merrill Lynch on Monday. The low-yielding yen rallied and safe-haven government bonds surged, sending the 30-year US.

Treasury yield below 4% for the first time since the early 1960s. Acute stress was building up in the interbank money markets, where the cost of borrowing dollars overnight shot up to more than three times the benchmark US interest rate of 2%. Liquidity injections from Asian and European central banks, to the tune of billions of dollars, did little to calm investors’ nerves in a market where world stocks hit their lowest level since December 2005.

An interest rate decision by the US Federal Reserve tops the day’s agenda after investment bank Goldman Sachs reported a 70% decline in Q3 profits and concerns grew about the state of American International Group. Interest rate futures fully priced in a chance that the Fed would cut rates to 1.75% later, with some analysts talking about a bigger half percentage point reduction.

“The market seems to be fairly convinced ... that the Fed will offer some form of monetary stimulus,” said Andre de Silva, global deputy head of bond strategy at HSBC. “The minimum the market is looking for is some sort of response to see whether that helps but the biggest risk now is not only financial market conditions -- we’ve had this market stress for over a year now -- but (also it) is more about what this translates into in terms of economic risk.”

The MSCI main world equity index fell 1.6%, its lowest since December 2005, after a 3.6% tumble on Monday. In September alone the index has so far lost more than 10% of its value and is on track for the worst monthly performance since September 2002. The FTSEurofirst 300 index fell 2.7% while Asian stocks fell more than 4%.

AIG, thrown a $20 billion lifeline by New York state, came under renewed pressure as ratings agencies downgraded the insurer’s debt. US stock futures were down as much as 1.3% after Wall Street suffered on Monday its worst performance since markets reopened after the September 11 attacks.

PANIC SCRAMBLE IN MONEY MARKET

There were signs that the deepening financial crisis is freezing up activity in the interbank money market. At one stage overnight dollar deposit rates rose to 11.6%, according to Reuters data, nearly six times the benchmark Fed rate. In the London interbank market, overnight dollar rates were fixed at 6.4375%. “The banking crisis is not over and we have potentially a difficult few months to get through right to the end of this year,” said Padhraic Garvey, head of investment grade strategy at ING. “The issue is that providing liquidity is one obvious solution but the reality is that the banking sector is not going to be happy till they have really sorted out the problem areas out there.”

The low-yielding yen extended its steep rise, with the currency hitting a four-month high of 103.62 per dollar. On Monday, the dollar suffered its biggest one-day drop against the yen in nine years. The yen hit a two-year high of 147.42 per euro while the dollar also fell against a basket of major currencies.

Safe-haven government bonds surged around the world, with the December bund future rising more than 100 ticks to a five-month high. The broad sell-off in risky emerging assets, already under pressure from slowing global growth, gained new momentum. Emerging sovereign spreads blew out to 407 basis points over US Treasuries, their widest level since April 2005.

Emerging stocks fell 4% to their lowest since October 2006. US light crude extended losses, falling 3.4% to $92.44 a barrel as investors extended across-the-board deleveraging, taking oil more than $50 off its record high set in July. Gold fell to $781.00 an ounce. (Reuters)