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Federal Reserve applies anti-crisis potion
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Federal Reserve continues to cut reference rate because of risk of recession in United States and drop on stock markets.
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In a drastic move on January 22 the Federal Reserve, the US central banking system, cut the reference rate by 0.75 points putting it at 3.50%. This decision was taken before the meeting of the monetary policy committee set for January 30 in a situation of fear of a sudden collapse of the stock markets. The amount of the cut was the highest n the past 23 years. The rapidity and sharpness of the move are significant and indicate the degree of perception of risk held by the central bank authorities.
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In a situation of economic slowdown and in view of the increase of downward risks in economic activity in the United States, the central bank authorities preferred to sharply surprise the markets in order to try to stabilize the situation. Furthermore, in the statement issued the Fed openly stated that it would continue to act decidedly in order to contain risks. In fact, on January 30, the monetary committee of the Federal Reserve decided to apply a further cut of 50 basis points in the reference rate.
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In contrast, in an appearance before the European Parliament the day after the first Fed cut in January, the governor of the European Central Bank (ECB), Jean-Claude Trichet, stated that at times of sharp upsets it was the responsibility of the central bank to maintain inflation prospects firmly under control in order to avoid increased volatility. He was joined in these statements by Axel Weber, member of the ECB governing council and chairman of the Bundesbank, who stated that, while the economic slowdown in the United States would certainly affect the rest of the world, its effects on the Euro Area could come later and that this time they could be gentler than in previous episodes. In all, the word from the ECB is it would maintain its policy of wait-and-see before making any decision on monetary policy.
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On other hand, European Central Bank maintains anti-inflation stand.
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The ECB statement is consistent with its monetary policy decision January 10 when it maintained the Euro Area official rate at 4%. While the monetary authority recognizes that expectations of economic growth have worsened and that risks for the economy are downward, it continues to maintain its central scenario in which growth this year will be close to potential. While it recognizes that consumer prices will hold above 2% because of the thrust of energy and food prices in coming months, it believes that the dynamic of prices itself will remedy the situation by the end of the year so long as there is no pass-through from price increases to wages.
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Interbank market interest rates slowly becoming normal.
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In the above table we note how finally the sum-total of injections of liquidity and interest rate cuts by some central banks has managed to reduce pressures in monetary markets. Normalization has been sharpest in those monetary areas where the biggest problems arose at the end of last year, that is to say, in United States and United Kingdom. Also in the Euro Area, the 3-month Euribor, which had reached 4.81% at the end of November, has dropped to 4.39%. For example, the 1-year Euribor, to which most mortgages in Spain are linked, broke with it upward course and while just a few months ago it seemed headed to 5%, now is running at 4.42%.
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China decides to raise bank cash reserve to cool off economy.
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Nor are things good in Asia seeing that, at its meeting on January 22, the Bank of Japan maintained its reference rate at 0.5% and recognized that growth in the Japanese fiscal year ending on March 31 would be lower than potential growth of 1.5%-2.0% due to the drop in real estate investment. Governor Toshihiko Fukui stated that he was maintaining the basic policy of normalizing the official rate as the Japanese economy grew. Nevertheless, the central bank governor had to admit that the body’s governing council faced a difficult situation due to uncertainty about the impact of the slowdown in the United States. The governor feels that the reason for raising the official rate gradually is to avoid any risk of over-investment that would make future growth over a long period unsustainable because of the creation of bubbles in all kinds of economic activity.
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In turn, in its struggle against inflation, the Chinese central bank again raised the cash reserves of trading banks to 15% effective from January 25. This is the eleventh increase in the past 13 months. This measure, was joined by the regulator of China’s financial system which announced it would make the terms for granting credits more restrictive in 2008 in order to counteract overheating of the economy.
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Long-term interest rates drop but credit restricted in Euro Area
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Long-term interest rates on government bonds drop because of economic slowdown prospects.
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Long-term interest rates on government bonds have dropped notably in the context of financial upsets. In spite of the fact that the ECB is maintaining its reference rate at 4%, the interest rate on 10-year government bonds in the Euro Area has fallen to 3.91%, that is to say, the interest rate curve is inverted. The most notable movement came in the United States where the 10-year bond has hit a price of 3.63%.
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There are two factors behind the drop in the government bond rate curves. First, the worsening prospects for growth in the United States and doubts about the impact of this slowdown on the rest of the world. This factor has led the market to discount rate cuts by central banks which has dragged the whole interest rate curve with it. The second factor is the flight to quality, that is, the selling of high-risk assets and the buying as refuge of risk-free assets, such as bonds issued by Euro Area governments and the United States. As the movement of bond prices and their return is inverse, massive buying has raised the price of government bonds thus pushing down the return offered by these assets.
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Flight to quality pushes interest rate curves down.
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The following graph shows the sharp shift of government bond curves in the Euro Area and the United States since the beginning of this year. Whereas on January 1 an investor could acquire a 2-year bond issued by a Euro Area government offering a 4% return, on the other hand, buying the same bond now would offer only an annual return of 3.4%.
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The drops have been sharpest in the short segments of the curves. In the case of the Euro Area, yields have been cut by around 60 basis points (100 basis points is 1%) while in the United States, in the 3-month to 2-year segments, the drops have been around 100 basis points. These movements came about in the first 24 days of the year, that is to say, movement has been rapid and very sharp.
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It is always important to know the situation for granting loans, information that takes on increased importance in a situation of financial upsets. From this point of view, it is useful to follow the survey carried out four times a year by the ECB about the situation on the granting of loans in the Euro Area. The ECB normally surveys 85 financial institutions and to make the inquiry significant it chooses the more important entities. The aim of the survey is to learn about financial terms and to complement statistics on the state of supply and demand for loans to companies and households in the Euro Area. Due to the financial upsets, the ECB decided to bring this survey forward and the results were made public on January 18.
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European banks confirm hardening of credit terms.
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The survey on the granting of loans reviews the fourth quarter of last year and prospects for the first quarter of this year. From the survey we may draw four conclusions. The first is that the tightening of granting loans to companies is being maintained and it is expected that this will intensify for large companies in the first quarter. Factors contributing to this tightening in order of importance are the worsening of prospects for the economic sector, increased cost of capital for banks and, to a lesser extent, reduced competition between banks to attract new customers in the business sector.
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The second point to be drawn from the survey is that the banks also foresee a bigger drop in demand for credit by the big companies compared with small and medium-sized companies in the first quarter of 2008. The main reason is the expected reduction of moves involving mergers and acquisitions and due to the increase in uncertainty and the postponing of some plans for investment in fixed assets.
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Widening differentials and demand for increased collateral are ways of tightening mortgage loans.
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The third important factor is that expectations for the real estate sector have made financial institutions more careful in granting loans to households to finance home-buying. This hardening has been implemented through increasing differentials and other commissions in the process of granting a mortgage loan as well as demanding more collateral in order to authorize the transaction. Finally, there continues to be a sharp slowdown in demand for loans by households to finance home-purchase. While consumer credit for households is also slowing down, for the moment it is doing so less sharply than in the case of housing loans.
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Foreign exchange markets reflect lower desire to take on risks
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Sharp volatility in foreign exchange markets.
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The widespread volatility in financial asset markets has also affected foreign currency markets. In the first week of the year the euro was priced at 1.472 dollars and went to an all-time high of 1.487 on January 14 only to weaken later on in a situation of high volatility. The accompanying table shows that the change in the euro against the dollar since the end of December last year was nil. This figure, however, hides sharp movements up and down.
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In general, it may be said that in January the dollar depreciated somewhat more than 5% against the Japanese yen and 3.5% against the Swiss franc.
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Investors reduce portfolios in yen and dollars and take refuge in Swiss franc.
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Factors affecting these movements are the different positions held by economic agents with the Federal Reserve cutting interest rates, the ECB maintaining its anti-inflationary stance and investors nervous about the prospects for corporate profits and doubts about the US economy. In the face of this situation, investment portfolio managers decided to reduce risk, which resulted in an appreciation of the yen causing them to cut borrowing positions in yen. Furthermore, the weight of the dollar was reduced and refuge was taken in the Swiss franc which often acts as a reserve currency when financial upsets are on the increase. Nor was the British currency left out seeing that investors abandoned the pound sterling in view of the prospects of bigger interest rate cuts in the United Kingdom.
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Year begins with more drops in share values
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Fatal week in stock markets...
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Since the beginning of December last year the largest world stock exchanges have dropped between 14% and 20%. The only exception was the Nikkei index for the Japanese stock market which began its drop in mid-October last year and since then has accumulated a drop of 22%. But events in shares sharpened in January. On Monday, January 21, when markets in the United States were closed for the Martin Luther King holiday, the Asian and European stock markets reported major drops.
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One of the factors setting off the crisis of confidence among investors on Monday, January 21 was the announcement on Friday, January 18 of cuts in the credit ratings of some major US credit insurance companies, the so-called monoline insurers. These companies insure bond issues carried out by other issuers that hold a rating lower than the AAA maximum. In case of default, the monoline insurer promises that the investor will receive all the money. In return, the issuer pays a premium.
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The strategic importance of these companies lies in that they have insured issues for a value of billions of dollars. The losses that could take place in the US financial system could be of such an order of magnitude that they could cause a risk to the system. The cuts in the ratings of these insurers would have meant lowering the classification of bonds issued by an amount of 2,400 billion dollars, with the subsequent impact on prices, reorganization of portfolios and using up of bank capital for those issues that are included in the financial balance sheets of financial institutions.
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...set off by drop in credit rating of monoline insurers, among other factors.
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Another factor weighing on the spirits of investors was doubt about the speed and efficiency of the start-up of the US Treasury’s fiscal plan because of the technical difficulty of having the key measures of a fiscal shock plan ready before the middle of the year. In addition, the drop on Monday, January 21 could be made worse by the transactions of Société Générale on ridding itself of fraudulent positions created by an operator in the futures market.
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Action by Fed calms down markets but volatility on increase.
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In any case, in view of the danger that the collapse could be repeated the next day in the US market, the Federal Reserve took the extraordinary decision to cut the official interest rate before the markets opened. The drop in the Fed’s rates made a strong recovery possible on Tuesday but Wednesday saw significant drops of approximately 5% when the ECB stated it was not ready to lower its rates. Nevertheless, the stock markets recovered on Thursday and Friday going up around 8%.
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The recovery seen at the end of the week (January 24 and 25) was largely due to the meeting held by insurance regulators in New York State with the main banks in order to draw up a rescue plan involving recapitalization of the monoline insurers in order to guarantee the stability of the financial system. Nevertheless, the market has still not established stable levels and volatility remains high.
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