Daily Market Reports | Mar 12 2008
By Greg Peel
The pervading theme of the credit crunch to date has been that while the Fed has been madly cutting the cash rate the benefits had stopped abruptly at the commercial banks who then sat on the liquidity to preserve their own capital. In the meantime out in the real world housing prices continue to slump, defaults continue to rise, and the cost of a mortgage continued to rise as no one was prepared to buy mortgage-backed securities, even if they were AAA.
This has precipitated the very near collapse of mortgage houses such as Countrywide and Thornburg, and the routing of the share prices of investment banks including Citigroup and Merrill Lynch. Caught in a credit market freeze, the lenders and brokerages were forced to heavily write down the value of all their asset-backed securities and risked an erosion of capital from which they may not have returned. As late as yesterday, rumours circulated that one such investment bank – Bear Stearns – was close to going under. Bear Stearns’ business model relies more heavily on security origination than any of its peers, and notably it was the investment bank that set in train the whole credit crunch in July.
Did the Fed last night act in direct response to Bear Stearns? Whether or not that’s the case matters little. The Fed has cut the cash rate by 2.25% to date and the situation has only become worse. Credit spreads are higher, stock prices are lower, the economy is in recession (as far as most are concerned), the US dollar is a third world currency, and as such commodity prices have run rampant, causing soaring inflation.
Markets were expecting another emergency rate cut of perhaps 75 basis points. The Fed tried this move in January and it affected merely a blip before the walls closed in once more. Many experts were calling for the Fed to stop playing rate cut and to target its emergency actions surgically – directly to the source of the ongoing problem. And so it was that last night the Fed announced a US$200bn liquidity injection (that’s 25% of the Fed’s balance sheet) straight into the primary dealers, that is, the investment banks.
The injection will take the form of a 28-day swap of hitherto unswappable federal agency debt, Fannie- and Freddie-issued mortgage securities and, most importantly, “private label” AAA-rated residential mortgage-backed securities – the stuff sitting on the balance sheet of every investment bank with no buyer in sight – into US Treasuries. But the Fed has not gone it alone. The deal involves a coordinated effort with the ECB, the Bank of Canada and the Swiss National Bank, in which US dollars are switched for euro, Canadian dollars and Swiss francs.
It is not a definitive rescue plan, however. It is a “time out” for 28 days, allowing struggling investment banks to restabilise their capital bases and avoid margin call crunches at least in the short term. It is designed to diffuse the potentially irrational panic that had beset the market. The investment banks will have to take the troubled mortgage securities back in a month, but the Fed has indicated it will likely re-offer the deal again, and perhaps as long as needed.
Wall Street responded rather positively. The Dow jumped 415 points, or 3.6%, gaining momentum toward the close. It was the biggest percentage up-move in five years. The S&P jumped 3.7% and the Nasdaq a full 4%.
The rally began immediately in the futures market after the Fed announcement, before the opening bell. Into the physical market, lunch time did see the strength begin to waver. The reason why was that those Bear Stearns rumours were persisting. Like many a session before in 2008 it appeared as the response might be nothing but a short-covering rally in a heavily oversold market. But Bear Stearns management once again officially stated their complete ignorance of why the rumours had begun, and the market was appeased.
But is it still just a short-covering rally? The good news was that this time the volume on the NYSE was substantial. As was the ratio of advancers to decliners. It appears that there were at least some investors who came off the sidelines and back into the game last night. With the Dow and S&P now having retraced back above their January lows, the talk is of a technically bullish double-bottom.
So how far has the rally taken the market? Well, back to above the close of last Thursday. There is still plenty of scepticism out there, and plenty of suggestion this is no less than an expected short-term bear market rally sparked by a piece of good news in a heavily oversold and panicked market, and that such a rally is an opportunity to sell once more.
The flipside of the Fed action is that uncertainty now surrounds the rate cut situation. Was it in lieu of an emergency rate cut, a large rate cut, or any rate cut? Is this the Fed’s means of avoiding the inflation ramifications and dollar weakening of a rate cut altogether, or will it still cut by 50 points next week as part of the package?
Either way, the dollar made its statement last night, rallying against all major currencies. Bond yields surged as investors jumped out of bonds, where cutting is now in doubt, and into the stock market, where the financial sector led the charge with 5-10% gains in the investment banks, and gains of around 15% in the mortgage lenders and home builders. (Bear Stearns was the exception, recovering to only a small gain.)
The credit spread on the London Interbank Offered Rate (Libor) finally eased. This implies the same will occur to the BBSW rate in Australia today – the source of local bank funding.
The dollar rose despite the announcement that the surging oil price had once again caused the US current account deficit to blow out. Despite the rising dollar, oil rose another US85c to another new high of US$108.75/bbl.
What was a gold trader to do? The easing of the panic, the potential for a rate stall, and the rising dollar, could have been enough to set off a big divestment in gold. But is this Fed action a panacea or a temporary reprieve? Does it simply represent a transfer of mortgage security risk from the investment banks to the Fed for a while, once again thwarting the free market need for the weak to fall and the strong to rise? The oil price still rose, and the deficit blew out. Conclusion? Gold fell US$1.40 to US$973.00/oz.
It might also have been expected that the Aussie dollar would fall victim to a rising US dollar, but as the greenback rose against the yen and panic was averted the carry trade can go back on, and as it was the Aussie rose over US1c to US$0.9286.
The base metal market was similarly in a quandary, as technical traders played out against the rising dollar, news that South African aluminium production was not as badly affected as first thought, and news of new supply disruptions in copper. All up it was a volatile session ending up mostly lower. Not that this had any effect on the US materials sector, which surged along with the broad market.
The SPI Overnight rose 195 points, or 3.8%. This implies a physical open of the ASX 200 back over the 5300 mark, and well back above the previous January low. Let the games begin.
