A couple of stories confirm that, despite the peppy response of the equity markets and the return to more-or-less upbeat reporting in the financial media, the Fed’s 50 basis point cut has not restored normalcy to the sector most in need of aid, namely, the money markets.
Central bankers have limited and for the most part, crude tools. One of the concerns voiced in the run-up to the September FOMC meeting was that the credit market crisis was, as UCSD economist James Hamilton put it, “bank run on non-banks.” Thus, measures designed to shore up banks, like the use of the discount window, would have no impact, and a general rate reduction might or might not help the battered sector (a rate reduction won’t help problems related to transparency, and will have only a marginal impact on solvency) but would increase prices of asset classes that benefit from lower short term rates.
One sign of the limited impact of the Fed’s move: commercial paper outstandings are continuing to shrink. While the rate of decline has moderated, if the Fed’s intervention has worked, CP outstandings would instead be rising.
The decline in the U.S. commercial paper market slowed last week, after the Federal Reserve cut interest rates to shore up confidence in the credit markets.
Debt maturing in 270 days or less fell by $13.6 billion in the period ended yesterday to a seasonally adjusted $1.86 trillion, including a $17.3 billion decline in asset-backed commercial paper, according to the Federal Reserve in Washington.
The amount outstanding has fallen by $368.1 billion, or 17 percent, over seven straight weeks to the lowest since August 2006 as some issuers were shut out of the market. The decline is smaller than the previous week’s drop of $48.1 billion, a sign that the credit crunch in short-term debt markets may be subsiding following the Fed’s half-percentage-point reduction in its benchmark rate on Sept. 18.
“The commercial paper market is not deteriorating as fast as it was in August, but as long as outstandings continue to fall, it is not out of the woods yet,” Christopher Low, chief economist at FTN Financial in New York, wrote in a note to clients.
Note that in the acute phase of the credit contraction in August, CP outstandings fell by roughly $90 billion a week for two weeks running, then $60 billion the week after that.
John Authers of the Financial Times tells us that pricing also indicates that the commercial paper market is still traumatized:
Markets have had more than a week to digest the dramatic cut in the Fed Funds rate to 4.75 per cent. Has it worked?
It has stimulated equities…Intriguingly, it has also made money for commodity investors. The S&P GSCI non-energy commodity index is up a cool 16 per cent since the Fed cut the discount rate in August.
But the Fed was not acting for these people. It wanted to relieve the crisis of confidence in money markets, where doubts about the quality of collateral had sent soaring the rates at which banks could raise funds.
Here, there are two ways to look at it. The dollar Libor rate, at which banks lend to each other, fell by the full 50 basis points. Having touched 5.725 per cent, it is now 5.23 per cent.
In asset-backed commercial paper 90-day paper rates reached 6.25 per cent and have come back down to 5.37 per cent.
So the rate cut reduced the cost of finance, bringing it back down to the levels before the crisis. This is important.
But there is a second way to look at it. Normally Libor and commercial paper are closely tied to Fed Funds. Both tend to be only slightly higher than Fed Funds, reflecting only slightly higher risks. When those spreads suddenly widened, it signalled a crisis of confidence.
Those spreads are as wide as they were before the rate cut. In July, commercial paper traded at only 4bp above Fed Funds. That spread is now 62bp. Three-month Libor usually trades at 10 or 11bp above Fed Funds: that spread is now 45bp.
So the rate cut euphoria has not flushed the underlying lack of confidence out of the system. The money market shows banks are still fearful of ugly surprises in the next few months. Maybe that should temper the roaring equity and commodity markets.