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Friday Notes

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Rate cuts combined with rescue plans

Fri, Oct 10 2008, 11:44 GMT
by HVB Group Global Markets Research

HVB Group

• Wildfire. The financial crisis continues to spread. Not only does it now have European banks in a choke hold, it is also increasingly threatening the solvency of local and state governments (page 9) and even nation states – and impacting markets that were until now considered immune. The crisis is visibly pushing industrialized countries closer to recession.

• Measures. More and more countries are putting together systematic rescue plans – with eurozone members acting in an uncoordinated way – while central banks around the globe are attempting to revitalize markets with ever more liquidity under ever new funding facilities.

• Rate cuts. The ongoing financial and real economic meltdown also compelled central banks this week to slash benchmark interest rates in a concerted move. This failed, however, to stem the erosion of confidence. Hence, further rate cuts are on the agenda.

• Risk. For the ECB and the Bank of England, this is only the beginning of an easing cycle (page 7). And even the Fed, which has already lowered its target rate 375 basis points since the outbreak of the crisis, will have to ease further (page 4). And the risk of continuing distortions on financial markets doesn't rule out rapid and strong emergency rate cuts.

• Further topics:
  

  – Weekly Comment: Further decisive action is essential (page 2).

  – Data outlook: EMU: Industrial production stages technical recovery; US: Consumer spending continues to fall (page 13).

  – Market outlook: Risk aversion remains high; JPY benefits (p. 19).

Harder, Better, Faster, Stronger

Global policymakers have come out in force this week, launching a determined attempt to pull ahead of the curve and halt the precipitous deterioration in market sentiment. They have not succeeded yet. They must keep trying. They must keep hitting the market hard in the next few days and weeks with decisive measures to ensure stability in the financial sector and to offset the ongoing economic downturn. Earlier action would have been better. Coordinated EU action would have been better. But it is not too late, and what we are beginning to see now is a very powerful policy response. Global policymakers have their backs against the wall, they have nowhere to run, nowhere to hide – do not underestimate how hard they are going to fight now. Markets have been overcome by panic and hopelessness, and what we are seeing is like a bubble in reverse: it is irrational, contagious and seemingly unstoppable – but like all bubbles, this too will pop. And this is a bubble that policymakers should not be afraid to prick. They have to keep hitting harder, better, faster, stronger, because the next few days will be crucial.

On Wednesday, the Fed, ECB, Bank of England, Swiss National Bank, Bank of Canada and Riksbank simultaneously cut interest rates by 25-50 bp, and were joined by China which cut interest rates by 27 bp. The Bank of Japan expressed strong support for the action, but was obviously not in a position to join in, its policy rate being still at 0.50%. It was a strong display of unity, and most importantly it was a clear signal that all central banks are fully aware of the need for decisive action. The ECB more than reversed the rate hike enacted just over two months ago, acting on the decisive change of stance outlined last week. Moreover, the fact that China participated in the action is extremely important. It shows that the coordinated reaction is truly global, including now one of the key emerging markets. China is a key global player in terms of both firepower, measured by FX reserves, and growth potential. The fact that China is involved in tackling the global financial crisis further increases the chances of success.

The coordinated rate cut came as European countries rush to launch national plans to stabilize their national banking systems. Announcements of stabilization plans came from Spain, in the UK, in France, and finally in Italy. I expect more countries will follow. A coordinated action would have been much better, but this is a good second best. The UK’s plan is extremely well structured and impressively forceful. It addresses capitalization, liquidity and funding – the three key causes of financial paralysis. It includes clauses aimed at pushing banks to intermediate the liquidity into the real economy. And it deploys virtually unlimited firepower.

None of this has been enough to shake the markets out of their depression, and the inevitable question is whether this is too little, too late. I think not. There is no doubt that earlier action would have been preferable – policymakers had fallen well behind the curve, especially in Europe. But now that they are moving, they are moving fast.

I see three reasons for the disappointed and disappointing market reaction to these moves. First, markets are concerned about the impact of a recession which is probably already underway in most developed economies. Wednesday’s rate cuts will not stop it, although, together with further rate cuts down the line, they will make the downturn less severe and prolonged. Recession fears cannot be eliminated, but will stop biting once equity investors feel that enough downside has been priced in, and at this pace it might not take that long. Second, the lack of a timely coordinated response by EU policymakers inevitably undermined market confidence. The national plans coming on line would have had a much stronger impact had they been launched in a coordinated fashion – although they will probably be just as effective. Third, there is simply panic and hopelessness. This is a bubble in reverse: many market participants feel and believe that the correction is going too far, but no one has the strength of going against the flow. It truly is a bizarre situation if we all keep coming into work in the morning while gradually accepting the idea that the entire global financial system is about to be erased – a bit like going to work if you think the world will end at midnight.

Like a bubble at some unpredictable point inevitably pops, so this spiral of hopelessness will reverse – and by the speed at which markets are falling now, I think that point will come soon. Policymakers must keep fighting. They must keep hitting the markets with decisive measures in the coming days – the market will eventually surrender. What more can they do? Gordon Brown called on the G-7 to guarantee interbank lending in a concerted approach. This would be another very powerful measure. In the eurozone, the ECB could start acting as a clearinghouse for interbank transactions, guaranteeing interbank loans with the explicit backing of national governments. The summit in Washington this weekend will be a precious opportunity to launch new strong measures. Efforts to strengthen the financial position of banks, along the lines of the Spanish or the UK plan, will continue, to take counterparty risk off the table. As transparency in banks balance sheets is restored, capital from sovereign wealth funds and other strong investors should start being deployed.

Further rate cuts should and will be enacted, and another coordinated rate cut will follow Wednesday’s move if necessary. Rates should be reduced significantly further in the UK and the eurozone to partially offset the ongoing economic downturn and help ease financial stress. With activity indicators and commodity prices weakening, I expect headline inflation rates will fall rapidly in the coming months, and this opens room for significant monetary easing. This crisis is extremely serious but not intractable, and we should not underestimate the joint power of fully committed global policy makers – markets will take notice and turn around. The next few days will be crucial.

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Published on  Fri, Oct 10 2008, 11:50 GMT