Financial market turmoil is set to continue as uncertainty causes further re-rating of risk. Market liquidity has dried up. Global money growth remains excessive, but a sharp slowdown could quickly ensue as borrowers are unwilling to borrow and lenders to lend. Central banks can and will provide reserve money: at an unscheduled meeting today the Fed cut its discount rate by 50bps to 5.75%. But the danger of a significant shake-up in the US banking sector is pertinent. Do not expect the real economy to come to the rescue.
August is supposed to be a quiet month for financial markets. But not when uncertainty regarding the fallout from the US sub-prime mortgage market and CDO debacle is running high. Investors and lenders alike are scrambling to figure out what the size of the problem is and whether they are exposed to it. There is no authority on the global scene to come out with a credible estimate of the overall exposure. Over the next few months the papers will continue to serve news after news, uncovering the damage to various financial institutions. Further financial market volatility and increasing risk aversion are bound to come.
Market liquidity is drying up as demand for holding money balances is on the rise. The banks, currently deprived of the securitisation channel and unsure of the extent of the losses they face, have already tightened lending standards and become less willing to lend. Technically the global supply of money is still running at excessive growth rates. The following sentence appears in today’s FT, “Bank shares in Europe slumped again yesterday as investors grew increasingly concerned about the ability of financial institutions to raise funding in the short-term markets.” Central banks around the world can and will be prepared to provide the necessary liquidity to avoid a freeze on short-term money markets or sharply rising interest rates. In response to the events of the past few days the Fed had an unscheduled meeting today, cutting its discount rate to 5.75% from 6.25%. In its statement it also said that “the downside risks to growth have increased appreciably.” The likelihood of the Fed funds rate to start coming down within the next couple of months has now increased.
But the key to whether the current financial market turmoil is set to have major and lasting consequences for the US economy and equity prices depends on the extent to which the money-making institutions are exposed to the resulting credit default, and of course its size. If securitisation has indeed managed to pass the credit default risk originating from
the mortgage market woes onto the balance sheet of the non-bank financial institutions, the overall financial system has become more robust. Investors will lose money, the nature of the money-making process as observed over the past five years will most likely change and asset prices will be re-rated. But the Fed should eventually be able to boost broad money growth via the banking sector and to kick-start the economy, set in coming quarters to languish at below-trend growth rates anyway.
However, if the fallout from the current financial market turmoil has begun to hit US banks’ profits and importantly capital, it would not matter how much reserve money the central bank will be providing. Lower policy rates are unlikely to prevent a severe credit crunch, the slumping of broad money growth and the downswing of the already fragile real economy. At present it is difficult to assess the extent to which the banks are exposed in terms of their capital. They have exposure to the CDOs, the defaulting mortgages themselves, the special purpose vehicles that were created for the securitisation of debt and the hedge funds that funded holdings of the “toxic waste” with debt. But considering that
this credit crunch comes at a time when the global economy is stretched to the limit by large financial imbalances, the danger to the health of the US banking sector and its economy is pertinent. (A forthcoming Monthly Review will be analysing in detail the liquidity crunch and its likely effects on the economy and financial markets.)
Interestingly and importantly, current financial market troubles are finding the private non-financial sector in the US, and in most of the rest of the world, in rude health and equities not overvalued. As the story unfolds over the next two years equities could offer value, especially in Europe. But over the next twelve months US long-dated Treasuries should be a better bet.
Diana Choyleva