Global Markets Weekly - 4th February 2008

• US policy responses seem to be soothing concerns about a recession...
  It has been an especially eventful fortnight in financial markets, with steep market sell-offs and rallies, a rogue trader scandal and 125 basis points of interest rate cuts from the Federal Reserve (Fed). Recession concerns, which reached frenzied proportions in mid-January, seem to have receded. Improving sentiment should buoy equity markets in the near term. In fact, though, the outlook remains as uncertain as it was two weeks ago. Short-term swings in sentiment aside, the equity market will probably start fully pricing in a US recession.
• …but credit market worries are limiting the equity rally.
  Indeed, after a week of drastic Fed easing, a proposed fiscal stimulus in the US and investor sentiment reaching cyclical lows, a rally of 5% retracing only one-week’s worth of earlier declines, though welcome, is not that impressive. Equity markets are being held back by belated worries about the impact of the cost and availability of debt financing.
• Despite the Fed’s cuts, interest rates are rising for some borrowers.
  Although bond insurers are the bogeyman of the moment, they are just one aspect of the wider problem in most developed economies: as central banks cut rates, or the risk-free yield curve starts to price in rate cuts, effective interest rates in the real economy aren’t fully responding – and, in some instances, are rising.
• The bond market is now key to passing monetary easing on to borrowers...
  The monetary transmission mechanism – how central bank rates affect the real economy – depends on banks using reduced-rate short-term funding from the central bank to finance longer-term loans, which entail some risk. The growth of the ‘originate and distribute’ model of debt financing over recent years means that, in the US, the bond market is now a more important transmission mechanism than the banking sector. In 2006, 54% of the almost $4 trillion of US credit growth was corporate, municipal and agency bonds.
• …but some parts of it are drying up, threatening economic growth.
  The issuance of highly rated bonds has been unaffected by the recent reduction in risk appetite. Indeed, issuance totals so far this year are slightly higher than in 2007. By contrast, high-yield issuance has fallen to an 18-year low, currently at 10% of early 2007 levels. This shunning of risk in the credit market raises the cost of capital in the real economy and so reduces potential economic and equity earnings growth – even though official interest rates are falling.
• Bernanke has studied how the Fed helped cause the Great Depression...
  While equity investors have only slowly woken up to the importance of this transmission mechanism, one man who is well aware of the danger of a broken transmission is Fed chairman Ben Bernanke. In his academic career, he studied the Great Depression and financial crisis’s role in its origins. Bernanke developed the concept of the ‘financial accelerator’, under which a decline in credit growth is magnified into a general risk aversion by lenders which then propagates the initial downturn.
• …so we expect him to keep cutting rates aggressively.
  Ultimately, Bernanke agreed with Milton Friedman’s and Anna Schwartz’s earlier claim that the Federal Reserve caused the Great Depression by not cutting interest rates soon enough. To prevent the financial crisis developing into a negative feedback loop with the real economy, rates should be cut early and a lot. During the 1990s, the Fed received a timely reminder, as the Bank of Japan’s mistakes caused a lasting slump in Japan. Now, Bernanke is in a position to put his theories into practice. As he said at Friedman’s 90th birthday celebration in 2002: ‘Regarding the Great Depression. You're right, we did it. We're very sorry. But, thanks to you, we won't do it again.’ Expect the rate cuts to continue.

Indices, Interest rates and Inflation

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