Fed steps up action in its war with the liquidity death−spiral

Mon, Mar 17 2008, 11:22 GMT
by John Hardy

Saxo Bank

Dramatic moves may extend even further as market frets the next Bear Stearns. Fed likely to cut 100 bps tomorrow.

MAJOR HEADLINES – PREVIOUS SESSION

Overnight developments:

• US Fed Announces dramatic weekend measures of financing Bear Stearns buyout and lowering discount rate 25 bps.

• New Zealand Feb. Performance of Services Index out at 55.6 vs. 51.9 in Jan.

THEMES TO WATCH – UPCOMING SESSION

Key event risks today (all times GMT):

• Switzerland Jan. Retail Sales (0815)

• EuroZone Q4 Employment (1000)

• US Q4 Current Account Balance (1230)

• Canada Jan. Manufacturing Shipments (1230)

• US Mar. Empire Manufacturing (1230)

• US Jan. TICs Data (1300)

• US Feb. Industrial Production and Capacity Utilization (1315)

• Switzerland SNB's Roth to speak (1700)

• US Mar. NAHB Housing Market Index (1700)

• Australia RBA publishes minutes of last meeting (0030)

• Japan Feb. Department Store Sales (0530)

Market Comments

It seems we have now entered the event horizon of the feared systemic meltdown scenario. The market understandably finds the sudden liquitidy crunch-induced demise of a company as large as Bear Stearns highly unsettling. Now the market is a nervous wreck as it wonders how many more Bear Stearns are out there and how much worse things can get as the price action has shifted into parabolic mode with the overnight acceleration of JPY,CHF and EUR stronger. Note that the USD is actually faring better than the smaller currencies of the G10 due to its better liquidity. EM currencies are a no-fly zone at present.

The Fed has clearly moved into "failure is not an option" mode with the unprecedented kinds of actions we have seen over the weekend - like lending funds to finance the Bear Stearns buyout by JP Morgan and cutting the discount rate on a Sunday evening. This is drama on the high seas of finance. Expect the Fed to continue to consider any option in the days and weeks ahead.

The history of markets such as these, when price action shifts into parabolic price action mode, suggests that the duration of such moves is very short once this type of action begins to unfold. But we dare not forecast whether tomorrow's likely 100 bp cut from the Fed will provide a bottom for the USD, or whether this kind of action can be sustained for another 2 weeks. In any case, we're likely to see a cycle climax very soon. Another thing to note is that when the market moves into white-hot fear territory, pricing can become very irrational, so it is likely better to wait for signs of a recovery before jumping into contrarian mode. Options become justifiably expensive in this environment as volatility has shifted into gun-slinging mode.

The self-consuming nature of a liquidity crisis is the most disturbing thing about this whole situation - the idea that the move is what generates the move - in other words, as risk spreads increase, the flight to safety rises, which then increases the risk spreads that much more. We thought all of the fancy hedging tools the financial world had created in recent years had eliminated the possibility for action like we are seeing here - but this, my friends, is a good old fashioned 19th century style panic. In the 21st century, the Fed helped get us into the situation with ridiculously low rates and now must help us out again if we are to prevent a 19th century outcome.

One thing is for sure: we can all expect a very different financial market playing field in the years ahead with the total failure of so-called "financial innovation".

This week, more than ever, be very careful out there and keep leverage reasonable.