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The Ripple Effects of Frozen Money Markets

Thu, Oct 2 2008, 23:49 GMT
by Asha Bangalore

Northern Trust

The Ripple Effects of Frozen Money Markets

Latest evidence indicates that a thaw of frozen money markets is not around the corner. The spread between the 3-month Libor and the 3-month Treasury bill rate (see chart 1) is scaling new heights everyday. This reflects the intensity of suspicion about what is contained on the balance sheets of institutions.

The reach of this frozen money market is far and wide because it affects everyday activities of the economy. The cost of inter bank borrowing for the short-term has risen (see chart 2) by over 200bps vs. the target federal funds rate instead of a few basis points above the target rate. Firms are charged a spread above the Libor rate for their credit lines depending on the risk involved in their business. Anecdotal evidence of a sharp increase in borrowing costs and reduced credit lines for firms with sound credit history has already appeared in main stream media. If firms continue to face tight credit conditions, payrolls may not be met, payments to suppliers may suffer, and job losses will follow. The Senior Loan Officer’s Survey of the Fed has ample evidence of tightening of credit conditions which runs counter to the fact that the Fed has eased monetary policy.

On October 1, 2008, an Associated Press news story from California (Frozen credit market jeopardizes Calif. borrowing - BusinessWeek) ran as follows, “California's top financial officials on Wednesday warned that the nation's frozen credit market is threatening the state's ability to do short-term borrowing State Controller John Chiang said the constricted flow of credit presents "enormous challenges" for California as it seeks to borrow money to pay immediate expenses. He projected the Legislature's record delay in approving a state budget means California will run out of cash toward the end of October.” Another report on September 30, 2008 (Main Street at Risk from Frozen Credit Markets) noted that companies are “hoarding cash and taking defensive actions.” In other words, the malaise has spread from financial markets to the real economy.

An alternative to raise funds outside of banks is the commercial paper market, which in recent days has also shown severe problems (see chart 3). If there are doubts about the financial health of a firm the cost of borrowing shoots up. The GE-Warren Buffet deal is case in point, when alternative sources had to be sought. The tight commercial paper market also suggests that firms may face difficulties rolling commercial paper. It is not difficult to imagine the problems firms will face with smaller credit lines, higher hurdles to cross to raise funds outside banks, and weakening demand conditions. To summarize, the pain in Main Street is not visible yet.

Weekly jobless claims illustrate how the labor market continues to show the impact of underlying weakness of the economy. Initial jobless claims rose 1,000 to 497,000 during the week ended September 7. Hurricanes Gustav and Ike caused the number of initial claims to shoot up. The Labor Department indicated that hurricane-related filings were about 45,000. Excluding these claims, the level of initial jobless claims would be close to 450,000, which matches levels seen during recessions. Continuing claims, which lag initial claims by one week, moved up 48,000 to 3.59 million and the insured unemployment rate has now held at 2.7% for two weeks, the highest since October/November 2003 (see chart 5).

ECB Shifts To Easing Bias

For the first time in over five years the European Central Bank (ECB) today shifted its bias toward easing. In his subsequent comments, President Trichet stated that the ECB had “no bias” regarding future monetary policy moves, and refused to be drawn on the likelihood of a lower refi rate before year’s end. However, the Council reportedly discussed only two options: leaving rates unchanged or easing. The focus of the Council statement was on the negative impact of the ongoing financial market turmoil. Trichet also pointed to clear evidence of a weakening Euro-zone economy as domestic demand contracts and financing conditions tighten. He stated that lower oil prices and ongoing growth in emerging economies “might support a gradual recovery in the course of 2009” – which is a distinctly more pessimistic assessment than he was making in early September.

Trichet’s inflation forecast also shifted somewhat this month, from seeing the annual rate fall back to the 2.0% target “in the course of 2010” to anticipating price stability “at the beginning of 2010.” He did reiterate that, while weakening demand diminishes upside risks to price stability, “they have not disappeared.” Nevertheless, the overall tone of his press conference was decidedly dovish. The euro promptly fell against the US$ on expectations of a 25bps cut to the refi rate at the November 6 policy meeting. Interestingly, the Council and President also appeared to set the stage today for participation in a coordinated action with other central banks before then. With money market tensions still worsening despite massive central bank liquidity injections, rates at ECB auctions pushed to record highs, and Euro-zone economic data increasingly gloomy, the refi rate will very likely be 4.00% before the end of this year, and head still lower through the first half of 2009.

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Published on  Fri, Oct 3 2008, 03:22 GMT