Mar 2008

U.S Federal Reserve Rate Cut Leads Market Rally

The U.S Federal Reserve cut its benchmark rate by 0.75% last night to 2.25%. The discount rate had already been shaved by 0.25% just before the start of Asian trading on Monday, when the Bear Stearns rescue package was announced. Last night, the discount rate was cut by yet another 0.75%, to give a total cut of 1% for the week.

U.S policymakers have certainly put in a full week’s work. The recent downward evolution of the US financial panic has not been a money crisis; rather, it has been a credit crisis. The issue has not been the price of liquidity, which the U.S Federal Reserve has more direct influence over through its control of short-term interest rates; rather it has been the volume of liquidity available to financial system participants.

The U.S Federal Reserve has reacted to the situation by introducing a series of liquidity injection facilities into the U.S financial system. December saw the birth of the Term Auction Facility (TAF), which has since grown in size and scope. A week ago, in conjunction with other central banks, the Term Securities Lending Facility (TSLF) took shape. On Sunday, coincident with the aforementioned 0.25% cut in the discount rate, the Primary Dealer Credit Facility (PDCF) was introduced.

We view the 0.75% cut as a rather more impressive signal than a straight 1% cut that many were hoping for, as it leaves the window open for another 0.25-0.50% cut at the next U.S Federal meeting on April 30th. The interest rate market is fully expecting the glidepath of US policy rates to touch down below 2% by mid-year.

There were two dissenting votes noted in the U.S Federal Reserve’s accompanying statement, which spent some considerable time discussing the U.S Federal Reserve’s continued vigilance over inflationary risks. We view this as a well-considered stance, which brings the U.S Federal Reserve closer to the European Central Bank’s (ECB) inflationary concerns. This is important because of the significant depreciation in the US dollar that we have seen in the past weeks and month, witnessed in a mighty rally in EUR, and the lock-stepped move in crude oil and gold, as well as almost all other major commodity groups and currencies versus the USD.

Morgan Stanley highlights a speech given by Mr Bini Smaghi, one of the members of the Executive Board of the ECB, last September entitled, “The Exchange Rate Policy of the Euro" wherein Mr. Bini Smaghi details how some future intervention efforts could evolve.

Step 1 : Monitoring and assessing exchange rate markets and developments, in particular with respect to the underlying fundamentals;

Step 2 : Discussing market developments with the other major partners and assess the configuration of different exchange rate developments and policies;

Step 3 : Making public statements on the situation of the foreign exchange markets and on exchange rate policies;

Step 4 : Intervening in the foreign exchange markets.

Essentially, we are now between Steps 3 and 4. Verbal interventions have commenced. The next step will be for the U.S Federal Reserve’s to intervene in the foreign exchange markets, co-ordinated with the other major central banks, in particular the European and Japanese central banks. This is why we view the U.S Federal Reserve’s inflation comments as an important attempt at policy alignment with the Europeans.

The extraordinary actions of the U.S Federal Reserve, in walking the market back from the brink of spiraling panic, made last night’s cut announcement almost anti-climactic. As we commented in yesterday’s note, we should not underestimate the U.S Federal Reserve’s willingness to reassert control of the policy agenda, so as to get back “ahead of the curve”.

Even before last night’s announcement was made, earnings results by Goldmans Sachs and Lehmans were greeted with relief, with Lehman stock trading up some *40%, Goldmans up some *15%, and risk-premia in the mortgage securities market narrowing dramatically.

Morever, the equity market brought its pocketbook out to play at the table, with last night’s IPO pricing of the Visa credit card network - in which many banks have a major stake - going well. And all this only 24 hours after JP Morgan rescued a near-bankrupt Bear Stearns. We will continue to watch, to see, whether this marks an important turning point in the current credit crisis. The US dollar appears to have found some reprieve, and this could be a major interim driver of a turnaround in market risk sentiment globally.

* Source: Bloomberg, 19 March 2008.

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