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Market Sense

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Powder dry

Wed, Sep 17 2008, 09:10 GMT
by Yapi Kredi Bank Economic Research Department

UniCredit Group

The Fed kept rates unchanged today, a unanimous decision, in line with my expectations—although the call seemed increasingly close as the day progressed, with extreme liquidity hoarding, equity markets in the red and Fed funds futures pricing in a cut with certainty. I strongly believe this was the right move. With the market focused on the risk of new bankruptcies, starting with AIG, cutting rates today would have had little or no impact. Keeping rates on hold can be seen as a sign of confidence that markets can handle current stress levels, and keeps the Fed’s limited powder dry to tackle further financial shocks or a renewed deterioration in the growth outlook. Markets initially reacted well, with USD moving slightly stronger and equity markets taking the disappointment in their stride. Shortly after the FOMC’s announcement, news reports that AIG may obtain a support package from the Fed pushed equities in positive territory. The Fed has successfully stayed on the fence for the moment, to watch how this new phase of consolidation and deleveraging will rapidly unfold in the coming hours and days. The decision to let Lehman go under has suddenly heightened the pressure to purge, consolidate and deleverage the financial system, and the real question is how policymakers will handle the situation, to what extent they will attempt to control the unraveling through carefully selected support packages and by “facilitating” shot-gun mergers and acquisitions in the sector, and to what extent should they instead allow impaired companies to fail. The next answer might come as soon as tomorrow, with AIG. It’s another very close call, but I would bet on a joint public-private rescue operation—the risk is perceived as excessive by markets (unlike in Lehman’s case), and a decision to let AIG fail would run against the warning of some of the large financial players who have played a constructive role so far.

The statement was mildly more dovish than a month ago, but more hawkish than markets expected: the FOMC acknowledged that “strains in financial markets have increased significantly” and that “economic growth appears to have slowed recently”, and removed the reference to elevated inflation expectations. However, they confirmed the previous assessment of balanced risks, with both downside risks to growth and upside risks to inflation deemed of significant concern..

Today’s FOMC meeting was the climax of an extremely tense and volatile trading day, with markets experiencing the worst conditions of stress and uncertainty since the onset of the turmoil over a year ago. Before investors even had time to begin digesting the shock of Lehman’s bankruptcy, AIG came center-stage, its share price plummeting and downgrades by S&P and Moody’s underscoring its fragile liquidity position. As the company met with New York Fed and Treasury officials, New York Governor Paterson dramatically stated in a televised interview that “AIG has a day left”. Talks on AIG continued during and after the FOMC meeting.

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Published on  Wed, Sep 17 2008, 09:13 GMT