Interest rate rift resembles one that led to 1987 market crash

U.S. Pins Economic Hopes
on $200 Billion Liquidity Boost

By Ambrose Evans-Pritchard
The Telegraph, London
Saturday, March 8, 2008

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/03/08/cnusfe...

The Federal Reserve has again been forced to step in to alleviate extreme stress in the US credit markets, pledging $200 billionn (L100 billion) of emergency liquidity for the banking system.

The move culminates a dramatic week that saw yield spreads on Fannie Mae and Freddie Mac agency bonds surge to the highest levels in over 20 years. A panic flight to safety across the credit universe briefly drove the yield on 2-year US Treasury notes below 1.5 percent, a sign that investors may be battening down the hatches for a violent storm.

The Fed said the fresh money was needed to "address heightened liquidity pressures in the term funding markets."

A tentative rebound on Wall Street ran out of steam in late trading as shares slid perilously close to the January lows, deemed key support levels by technical traders. The Dow Jones index tumbled 202 points at 11,833 in late trading. Grim jobs data released by the Labour Department showed that employers had cut the workforce by 63,000 in February, the sharpest drop since the dotcom bust.

"A decline of that magnitude screams recession," said Paul Ashworth, US strategist for Capital Economics.

"This will prompt the Fed to slash rates rapidly to 1 percent. One thing that history teaches us is that when an economy stalls and drops into recession, things get very bad very quickly. There is no going back now. We are well past the tipping point," he said.

Ominously, the OECD club of rich states said its global "leading indicators" were pointing to a slowdown almost everywhere. "The latest data point to a potential downturn in China and India," it said.

BNP Paribas said the indexes measuring corporate default risk such as the iTraxx Crossover were flashing danger signals. "Credit market stress is intensifying with spreads reaching record wide levels on many measures. Risk appetite is being severely challenged," it said.

Goldman Sachs said the US was almost undoubtedly in recession, predicting that the Fed would now have to cut rates a further 100 basis points over the next two meetings as the full effects of the housing crash bite deeper.

Richard Fisher, head of the Fed's Dallas branch and the bank's leading hawk, warned investors not to count on an easy-money bailout.

"We reacted with very deliberate actions. That shouldn't lead markets to expectations that we will continue to react in that manner," he said.

"I would discourage you from thinking that simply because of a significant action in the credit markets, that suddenly we're going to move Fed funds rates in response."

However, Mr Fisher appears to be at loggerheads with the key Washington governors, led by Chairman Ben Bernanke. The Bernanke circle is now deeply worried about a systemic crisis, fearing that the "financial accelerator" may have set off a downward spiral that could prove hard to stop.

The Fed is now starkly at odds with the European Central Bank, which has held rates steady at 4 percent since the credit crunch hit in August.

Fed officials say privately that they are shocked by the ECB's complacency given that Italy is falling into recession while Spain and Ireland face property slumps.

The transatlantic rift is eerily similar to the disputes leading up to the Black Monday stock market crash in October 1987. Traders say the discord has begun to infect market confidence.

Yesterday's Fed action involves two sets of $50 billion infusions in March through the Term Auction Facility, and a further set of "repo" transactions expected to total $100 billion.

Ashraf Laidi, a currency expert at CMC Markets, said the move helped to stabilise the crumbling dollar after it touched a record $1.5450 against the euro.

"The liquidity operation may reduce the likelihood of a 75-basis-point cut this month," he said. The markets had been swept by rumours of another emergency meeting along the lines of the January cut.

The Fed is becoming increasingly concerned about the "wealth effect" as plummeting house prices and losses on the stock market combine to crimp spending.

Its "Flow of Funds" report this week showed that household assets had dropped 1 percent to $57.72 trillion in the final quarter of 2007, the first fall in six years. Mortgage debt is now greater than home equity for first time since records began.

* * *

GATA is grateful for financial contributions, which
are federally tax-deductible in the United States.