Just when market participants were patting themselves on the back, focusing on indicators that suggested the credit crunch was easing, even making forecasts that it would be behind us before year end, troubles creep back on little cat feet.
The proximate cause for Fed intervention wasn’t the subprime crisis or rise in agency spreads, but a seize-up in the money markets as banks exhibited a decided distaste for lending to each other in August and September. That led to (among other things) emergency rate cuts and Paulson launching his stillborn “save the SIVs” initiative. That worked only till November, when the difference between Libor and risk-free rates again rose, leading the Fed to launch the Term Auction Facility in December. Then trouble emerged on a new front, as agency spreads rose to attention-getting levels in late January. This appeared to be a vote of no confidence by the markets in various plans to use Fannie and Freddie as major actors in the rescue of underwater American homeowners. That resurgence of the debt crisis culminated in the sale of Bear Stearns, which many hoped was a watershed event and signaled that the worst was over.
We didn’t think so, and we appear to have company. Banks are still hoarding cash, which means the Fed’s heroic and ever-larger efforts have still not resolved the initial problem, namely, high interbank spreads. Its persistence suggests it may not be amenable to Fed action.
Update 2:30 PM Paul Krugman is not happy:
All of this involves fear of defaults by banks — despite what look from here (central New Jersey) like utterly clear signals from the Fed that bank debts will be socialized if necessary. I’m puzzled, and worried.
From the Financial Times:
Money markets in the US and Europe are signalling renewed fears about the financial strength of banks, with key confidence barometers almost returning to the levels that preceded the collapse of Bear Stearns.
The concerns are being highlighted by the difference between overnight lending rates set by central banks and three-month Libor, the rate at which banks lend to each other. This spread, known as the overnight index swap rate, has been rising in the US and remains elevated in Europe, indicating that banks are reluctant to lend to each other.
“Libor is still dysfunctional and, for whatever reason, banks still appear unwilling to lend funds,” said Dominic Konstam, head of interest rate strategy at Credit Suisse.
The difference between the overnight central bank rates and three-month Libor was typically about 12 basis points before global credit turmoil grew worse last summer.
In the US on Wednesday, that spread rose rose 2bp to 77.5bp. The difference had climbed above 80bp on concerns about Bear, then fell back to 60bp in mid-March after the investment bank was sold to JPMorgan Chase.
In the UK, the swap rate gained 2.45bp to 95.45bp on Wednesday. In Europe, the swap rate was up 1.29bp at 74.68bp. It had been 67bp after the Bear sale.
Investors also sought the safety of government debt on Wednesday, pushing the yield on the two-year Treasury down 12bp to 1.75 per cent.
Tensions are rising in the money markets in spite of the injection of huge amounts of liquidity into the banking system by central banks. Traders say market conditions suggest the Bear rescue has not completely alleviated worries about counterparty risks. Until confidence is restored, the availability of credit to investors and companies will be restricted, potentially hurting the broader economy.