FYI | Sep 01 2007
By Greg Peel
The Dow closed up 119 points or 0.9% on Friday, after having wobbled it’s way up as much as 190 points before a sharp square-up in the last half hour. The S&P gained 1.1% and the Nasdaq 1.2%.
Wall Street stumbled at the blocks on Friday morning as a ten page statement was released by Fed Chairman Ben Bernanke from Jackson Hole, Wyoming. A quick perusal did not reveal a sentence along the lines of “I will cut rates on or before September 18”. However, sentiment turned largely positive as the day progressed, albeit in thin, Friday-before-a-long-weekend volume. Aiding the mood was a statement made by President Bush which had been revealed to the press ahead of the Bernanke statement so as not to overload the market with too much to absorb at once. Bush’s speech thus had already had a positive effect on markets in Asia, Australia included, on Friday afternoon and in European morning trade.
But first to Bernanke. The following are select excerpts from the document (my headings):
The Problem:
“As you know, the financial stress has not been confined to mortgage markets. The markets for asset-backed commercial paper and for lower-rated unsecured commercial paper market also have suffered from pronounced declines in investor demand, and the associated flight to quality has contributed to surges in the demand for short-dated Treasury bills, pushing T-bill rates down sharply on some days. Swings in stock prices have been sharp, with implied price volatilities rising to about twice the levels seen in the spring. Credit spreads for a range of financial instruments have widened, notably for lower-rated corporate credits. Diminished demand for loans and bonds to finance highly leveraged transactions has increased some banks’ concerns that they may have to bring significant quantities of these instruments onto their balance sheets. These banks, as well as those that have committed to serve as back-up facilities to commercial paper programs, have become more protective of their liquidity and balance-sheet capacity.”
The Solution:
“The Federal Reserve stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets.”
The Moral Hazard:
“It is not the responsibility of the Federal Reserve – nor would it be appropriate – to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy.”
The Strategy:
“The incoming data indicate that the economy continued to expand at a moderate pace into the summer, despite the sharp correction in the housing sector. However, in light of recent financial developments, economic data bearing on past months or quarters may be less useful than usual for our forecasts of economic activity and inflation. Consequently, we will pay particularly close attention to the timeliest indicators, as well as information gleaned from our business and banking contacts around the country. Inevitably, the uncertainty surrounding the outlook will be greater than normal, presenting a challenge to policymakers to manage the risks to their growth and price stability objectives. The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.”
And on those notes, Wall Street has assumed that come September 18 the Fed will cut the cash rate by 25 basis points, and, if new data so determines, it will continue to cut rates in order to avoid a sharp economic slowdown. Given that the market expects more timely data such as jobless claims and consumer confidence to be poor, the futures market is still assuming a total 100 basis point cash rate cut by year end.
Bernanke took time in his statement to explain the thinking behind the August 17 cut in the Fed’s discount rate. But as The Problem above suggests, and as the evidence confirms, the discount rate move has not affected a sufficient movement of liquidity into the vital asset-backed corporate paper market. Throughout the month of August, the Fed has steadfastly attempted to reignite credit markets without having to resort to an emergency rate cut. It has pumped liquidity into the overnight cash market, such that the actual cash rate has fallen as low as 4%, despite the current target of 5.25%, and it cut the discount rate by 50 basis points. Clearly the Fed was concerned that an emergency rate cut would be seen by the greater public as a “bail out” of greedy Wall Street investors who have lost their shirts on arrogant and foolhardy risk taking. Public perceptions aside, the Fed wanted to precipitate a painful but necessary repricing of risk without resorting to inflationary measures. Those who live by the sword should die by the sword.
However, as we enter September we still very much have The Problem. The Solution does not, at face value, appear to be any different to any statement made by Bernanke between August 17 and Friday, but when combined with The Moral Hazard it becomes clear that Bernanke has decided that if it’s a rate cut the financial system needs, then a rate cut it will get. To not cut rates would be to risk corporate insolvencies, job losses, and an economic recession. To that end, morality takes on a wider implication. The victim would become Main Street as well as Wall Street.
Had Bernanke not made his statement on Friday then the market may well have felt uncomfortable with the economic data released on the day. Uncomfortable because the numbers were, economically, good. Factory orders rose 3.7% in July against an expected 3.3%. Within that number was the biggest increase in new car orders in four years. The Chicago purchasing managers’ index rose to 53.8 in August from 53.4 in July. These numbers hark back to the Fed’s recent concerns of inflationary pressure and may have otherwise cast doubt over an impending rate cut. But the core personal consumption expenditure (PCE) measure of inflation edged up only slightly in July, implying year on year inflation of 1.9% – within the Fed’s earlier comfort zone.
Nevertheless, The Strategy above suggests the Fed has acknowledged what many an analyst has suggested of late, that backward-looking data are really of little use in determining the state of the economy in this time of turmoil. Hence the Fed will now focus specifically on only “the timeliest indicators” before launching into monetary easing – that which the Fed would really rather avoid.
So from here on it will be a case of watching closely for any signs of economic slowdown, and watching closely developments in the commercial paper market. Any adverse news will be met with necessary action.
The other statement that spurred on Wall Street last night was President Bush’s announcement of a package of measures to assist Americans facing mortgage difficulties. Administration officials briefed the media on the new initiatives on Thursday night. The New York Times reported:
“The officials said Mr. Bush would call for the Federal Housing Administration to change its federal mortgage insurance program in a way that would let an additional 80,000 homeowners with spotty credit records sign up, beyond the 160,000 likely to use it this year and next.”
In addition, the Administration would lean on mortgage lenders to go easy on stricken homeowners facing ominous refinancing and rate adjustments. Furthermore, the Administration would look to provide tax relief to foreclosed mortgagees. Americans currently face a tax on the value of loans effectively “forgiven” by lenders in the event of foreclosure. The intention here is not to bail out those foolish enough to undertake mortgages they could not afford. The intention is to provide support to those low income homeowners who had provided documentation, who have made their mortgage payments to date, but who have now been caught up in a credit crunch created by the laxity of others.
While these initiatives were received positively by the market, there was still plenty of room for critical assessment, to wit:
(1) This is simply a political response to pressure from the Democrats.
(2) 80,000 homeowners is a drop in the bucket of potentially some 2 million or more who may now face difficulties.
(3) What pressure can the Administration really apply to lenders? In days gone by a mortgage holder in a spot of bother could meet with the bank manager and negotiate some interim relief. Foreclosures are not in the best interest of banks. But the mortgage lenders of today have on-sold their loans ultimately into investment vehicles held by hedge funds. The mortgages may not be easily negotiable.
Whatever the criticisms, Wall Street has gone into the long weekend feeling slightly more comfortable, if not exuberant, following both Bush’s and Bernanke’s statements. The question now is just how far will the Fed have to go to ultimately end this credit crisis? The Fed is poised ready to be reactive, not proactive. The extent of global disfunction has not yet been fully revealed.
Reactions in other markets were predictable. Gold posted a US$8.40 rally to US$673.40/oz, breaking out of its narrow trading range of recent weeks. Gold responded to stock market strength, but also to the inflationary implications of Fed rate cuts. The US dollar closed mixed against other currencies, but the notable feature of last night was that the yen rallied against the US dollar, and so did the Aussie dollar. Carry trade considerations gave way to interest rate differentials to see the Aussie back to US$0.8188.
Base metals surged in London as a first reaction, before slipping back toward the close. Lead was the only metal not to close higher, while nickel was the star performer, closing in New York with a near 6% gain. The rallies came in the face of data suggesting a build-up of inventories at the LME. Oil shot up another US68c to US$74.04/bbl.
The SPI Overnight put on a further 14 points. While this may seem a fairly muted response, Friday’s rally in Australian equities was assisted by the pre-release of Bush’s statement.
Monday is a holiday in the US.
