Global Markets Weekly - 25th March 2008

• The Fed acted decisively on several fronts, throwing its discount window wide open...
  No one could accuse Ben Bernanke, the Chairman of the Federal Reserve (Fed), of inactivity. Faced with the collapse of Bear Stearns on Friday, the Fed announced on Sunday that it would open its liquidity-providing ‘discount window’ to a wider pool of investment banks and brokers – a privilege usually granted only to a small number of commercial banks. These banks can now give the Fed a wide range of collateral – including mortgage-backed securities – and receive cash in return. In other words, for the time being, the Fed is underwriting the liquidity requirements of the US banking sector.
• …which makes it almost impossible for a big US bank to fail...
  The upshot is that the sudden liquidity-driven failure of any large US bank is now effectively impossible. So the panic selling of financial stocks immediately after the announcement was puzzling and was fairly quickly reversed. Of course, it isn’t good to have reached a position in which the Fed deems it necessary to offer such a broadreaching liquidity guarantee. But, having reached that position, it’s clearly better to have the guarantee than not.
• …but does not bail out the banks' shareholders.
  Though guaranteeing the integrity of the system, the Fed’s action does nothing to insure equity holders in financial companies – or, indeed, any sector. From investors’ perspective, therefore, we can say that bond-holders have been disproportionately advantaged relative to equity holders.
• Investment-grade spreads came in significantly but may have further to go.
  As a result, investment-grade credit spreads tightened markedly last week. Two weeks ago, we noted that valuations in this sector of the credit market had cheapened to levels that were difficult to justify by reference to default rates in previous recessions. In particular, the investment-grade iTraxx index was pricing in double the highest default rate seen since 1970. Investment-grade spreads have now unwound most of their March widening and, especially in light of recent Fed action, may have further to rally.
• The Fed also cut interest rates by 75 basis points...
  As well as micro-managing the financial infrastructure, the Fed wielded its more conventional policy tool of interest rate cuts, reducing the Fed funds rate by a further three quarters of a percentage point, to 2.25%. However, the Fed's accompanying statement appears to have been largely overlooked by investors, coming as it did in the wake of Bear Stearns’s collapse and the more unconventional policy response.
• …but stressed the risk of higher inflation, casting doubt on the scope for future cuts.
  Interestingly, the statement placed greater emphasis on the upside risks to inflation and noted that two members of the Federal Open Market Committee had voted against such a large cut, preferring a more modest move. Given that the market consensus expectation before the announcement had been for a reduction of one whole percentage point, it would seem that the final decision was a compromise. With rates having moved so low so quickly, we may be seeing the start of a breakdown in the broad consensus which had prevailed in favour of lowering rates in order to protect growth while placing inflation concerns firmly on the back burner.
• If inflation concerns return to the fore, that could hurt risk assets.
  For now, investor sentiment appears to be bouncing off its post-Bear Stearns lows, as investors focus on the Fed’s more market-friendly unconventional policy. However, if a perception were to develop that the Fed was becoming more reluctant to cut rates, that could have a negative impact on risk appetite down the line.

Indices, Interest rates and Inflation

	Close 24-Mar-08	1 Week%	1 Month%	3 Months%	YTD %
FTSE ALL Share	2,814	1.3	-6.6	-14.5	-14.4
FTSE 100	5,495	1.5	-6.7	-15.2	-14.9
S&P 500	1,350	5.7	-0.2	-9.8	-8.1
Nasdaq Composite	2,327	6.9	1.0	-14.3	-12.3
DJ Stoxx (Europe)	334	1.9	-6.6	-19.1	-19.4
Nikkei 225	12,480	5.9	-7.6	-18.2	-18.5
Hang Seng	21,108	0.1	-9.4	-25.0	-24.1

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Jun-08 Forecast	Sep-08  Forecast	Current	Next Date
US (Fed Funds)	2.25	1.50	1.75	4.0	30-Apr
UK (Base rate)	5.25	5.00	5.00	2.5	10-Apr
Euro-zone (Repo Rate)	4.00	4.00	3.75	3.3	03-Apr
Japan (Call rate)	0.50	0.50	0.50	0.7	08-Apr

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