FYI | Aug 16 2007
By Greg Peel
Yesterday the Australian stock market passed the 10% correction mark on its way down. Last night the US broad market S&P 500 hit 9.6% down and the Nasdaq hit 9.8% down. The Dow, which closed down 167 points, falling 255 points in the final two hours, reached 8.1% down. The Dow is the greatest psychological equity indicator in the world, but as an arithmetic average of 30 stocks it really isn’t a great proxy.
The rule of thumb is that a correction must reach 10% before it is truly a correction. The Dow thus has more to go and maybe then the world will call the correction. Having peaked at 14,000 on July 19, it fell below 13,000 for the first time last time last night, reaching 12,861.
But the question now is: is 10% enough? Pretty much everything suggests not. Particularly the psychology of fear.
Last night the US Fed injected another US$7 billion into the banking system, having stayed out of the market on Tuesday. It accepted US$4.5 billion of mortgage-backed securities as collateral but remember – this is not the Fed “buying” distressed securities in order to bail out the financial sector (which some are advocating it should do). It is merely short term collateral that has to go back in.
This injection came on top of the US$64 billion the Fed has put in since last week. Is it working? Apparently not. The Fed funds target rate was kept steadfastly at 5.25% earlier in the month but the reality is that cash is now trading at 4.5%. In other words, the de facto Fed rate is now 75 basis points below its stated target. When you consider how much equity markets have agonised over the possibility of every little 25 basis point move these last two years, imagine what a one-step 75bps easing would have done for the stock market under normal circumstances. It would have sent it to the moon.
But it hasn’t. There is plenty of liquidity in the system now but the whole point of the injections is to quell the credit crisis. Non-bank financials are looking at becoming insolvent overnight if they can’t raise required funds. These injections should help, but still no one is lending to the troubled institutions. The money is instead pouring onto 90-day US Treasury bills – the most liquid and probably the “safest” haven investment in the market. Yields have collapsed from 5% to 4% in less than a week. This is quite extraordinary.
Verifying the indications that the injections aren’t working is the ongoing fate of the biggest US non-bank mortgage lender, Countrywide. Last night Merrill Lynch downgraded the lender to a Sell and the stock fell yet another 13%. Countrywide paper – that which it sells to fund its mortgage portfolio – is trading at 12.5%.
Overnight cash 4.5%, Countrywide paper 12.5%. That is the exactly the problem facing this market, and the reason why, for the moment, there is little hope in sight for a bounce off the “correction” low in any meaningful way.
The late sell-off occurred despite a few positives. For one, yesterday’s train crash – Thornburg Mortgage – saw its shares rebound 33% (from 46% down) after an appearance on CNBC by the CEO calmed panicked investors. Amazingly, Lone Star private equity said it would extend its tender offer to take over distressed Accredited Home Lenders after all.
The big news, however, should have been the July CPI, which came in at an as-expected mere 0.1%. When last Bernanke spoke, he was still touting inflation concerns. Now many in the market are screaming out for rates to be eased. Clearly a low CPI removes immediate inflation fears and opens that door.
But the Fed, in reality, has already eased. It is allowing cash to trade at 4.5%. Some commentators suggest the Fed must now come in and officially state it has lowered the target. This, they say, is the psychological impetus required to halt the panic. And without moving the target, the assumption is the Fed must eventually pull its injections back out.
But on the flipside you have the argument: why should the Fed bail out the non-bank financials and hedge funds and others who have blown themselves up by their own hand? To that the answer is: because it’s alright if a whole lot of fringe players go down, but it is the Countrywides of the world that are staring at insolvency for no good reason. It is estimated there is currently US$2 trillion of commercial paper that has to roll over. If it had to roll over at the sort of price Countrywide can only achieve, it won’t. That would be catastrophic.
Well that’s the bad news, now for the bad news.
Since almost returning to the 2006 peak above US$78/bbl earlier in the month, the oil price had been falling ever since on concerns of a US economic slowdown. Well those concerns have now moved to backstage as disquieting news is emanating from the National Hurricane Center. Tropical storm Dean is strengthening in the Caribbean and heading west. It could be a major hurricane by tonight. Tropical storm Erin has entered the Gulf of Mexico. After rising strongly on Tuesday, oil was up another US95c to US$73.33/bbl last night.
Limbo remains in other markets. Gold was steady, as were ten-year bonds. Base metals mostly held fast. The US dollar continued to edge up against the euro (the ECB has injected significantly more funds than the Fed) and the pound (the BOE has injected no funds so go figure). It continued its fall against the yen, however, meaning more carry traders dumped the Aussie. It is now just above US$0.82.
The fate of the US dollar will depend on whether or not the Fed does actually cut rates officially. There is talk of 50bps initially followed by another 50bps being needed. Clearly the Fed will be wary of what sort of effect that would have on the US dollar.
Despite the 3% fall in the local market yesterday, the SPI Overnight was down another 79 points.
