Most U.S. primary dealer banks expect fed funds rate cut soon

Calm After Fed Move Turns to Uncertainty

By Kevin Plumberg
Reuters
Monday, August 20, 2007

http://www.reuters.com/article/bondsNews/idUSL2068258020070820

NEW YORK -- The initial euphoria in financial markets after Friday's Federal Reserve discount rate cut faded on Monday, and questions began to be asked about what more needed to be done to improve confidence in lending.

On Friday the Fed cut the rate at which it lends directly to banks, and it encouraged lenders to use its discount window in an attempt to restore confidence in credit markets which had been concerned about the extent of losses in the U.S. subprime mortgage market.

Deutsche Bank reportedly borrowed funds directly from the Federal Reserve on Friday, although it was unclear how much, the Financial Times newspaper reported on Monday. Banks are typically wary of tapping the Fed's discount window for fear it will be taken as a sign of cash flow or balance sheet weakness.

Global stock indexes rose modestly on Monday in a relief rally, after the Fed's move on Friday, but investors looking for safety continued to buy short-term Treasury debt, with the 3-month yield seeing its biggest daily fall since the stock market crash of October 1987.

Asian stock markets rallied while European equities chalked up modest gains.

The Fed's action on Friday may have given investors only momentary respite from worrying about the extent and distribution of losses emanating from defaults in the subprime mortgage market.

"The problem is not that the expected losses from subprime mortgages in the aggregate are too great for the system to bear," said analysts at Wrightson ICAP. "Rather, the problem is that the losses will undoubtedly be too much for some individual players to bear, and nobody knows which ones," they said in a research note.

The broader credit market seemed far from normal on Monday, particularly in the housing sector, where prices are falling and defaults on mortgages are rising.

"Investors' confidence in the mortgage financing space is not doing well," Larry Goldstone, chief operating officer of Thornburg Mortgage Inc., said in an interview with CNBC television on Monday.

In order to meet funding obligations, Thornburg said it has sold $20.5 billion of assets and reduced short-term borrowings by an equivalent amount.

Adding to the uncertainty among investors, Fannie Mae, the largest source for U.S. home loans, said it will skip its monthly benchmark note issuance in August for the first time since May 2006.

"Things have stabilized from last week but the worst isn't over yet," said Michael Pond, Treasury strategist at Barclays Capital in New York.

Away from the trading rooms of Wall Street, policy-makers around the world struck a sanguine tone about the impact of market volatility on the global economy, even after the Fed said on Friday that the risks of the U.S. economy slowing have grown "appreciably."

Canadian Finance Minister Jim Flaherty told reporters on Monday that it would take "some time" for the turmoil in credit markets to be resolved, but that the fundamentals of Canada's economy remain strong.

Germany's Bundesbank said the outlook for the global economy remained positive despite recent market tension, which represented a "welcome normalization", albeit an abrupt one.

"Nevertheless, the risks for the global economy have increased with the correction process in the U.S. property market," the German central bank said in its monthly report.

Central banks remained on alert on Monday.

In the wake of the market volatility, investors have sharply altered their forecasts for monetary policy. They expect the Fed, which added another $3.5 billion on Monday in short-term liquidity, to cut the federal funds target rate, the central bank's main monetary policy lever.

More than half of U.S. primary dealer banks polled by Reuters predict the Federal Open Market Committee will lower the fed funds rate at its Sept. 18 meeting, or even earlier.

The Bank of England is no longer expected to raise rates again this year. The European Central Bank said it would again allot more funds than strictly necessary at its weekly tender, but aimed to reduce surplus liquidity in the short-term euro money market gradually as conditions normalize.

Australia's central bank also injected a sizable amount of liquidity into the banking system, seeking to temper upward pressure on some short-term money market rates.

But few investors are confident that the liquidity crisis and credit squeeze stemming from the U.S. home loan market have yet seen the light of day, and they fear further market volatility could cut economic growth.

U.S. Sen. Richard Shelby, a member of the U.S. Senate's Banking, Housing and Urban Affairs Committee, said banks would increase their mortgage rates in the coming weeks, exacerbating tight credit. "I think it will get worse before it gets better," Shelby said in Brussels. "There will be firms that will not survive. I don't think we should bail them out."

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