The stock market has got the Fed’s message, the money market has not. Unfortunately, the message was intended for the money market, notes the FT’s John Authers in Tuesday’s Short View column.
Stocks “bounced” after the Fed’s Friday decision to cut its discount rate, making it easier for banks to borrow. This was not surprising, says Authers:
Historically, the discount rate — governing the rate at which the Fed lends to banks — has moved less frequently than the Fed Funds rate, which covers the rate at which banks lend to each other.
When it does shift, academics such as Robert Johnson of the CFA Institute point out, it has a strong effect on stocks, because it is seen as an unambiguous indicator of future monetary policy. Stocks like rate cuts.
But the Fed was not aiming to bail out stocks. Rather it was prompted to act by extreme conditions in the money market.
As the FT notes in Tuesday analysis, companies faced acute difficulties raising finance with asset-backed commercial paper, a key way to raise short-term funds. Loss of confidence in collateral, in the wake of the subprime debacle, on Tuesday prompted investors to fly to quality. On Thursday, the three-month Treasury bill yield fell more than 50 basis points, as investors piled in to the world’s safest and most liquid securities.
“This was such an extreme event that the market bet that the Fed would be forced to react. Hence the rally,” explains Authers.
On Friday, the three-month Treasury-bill yield fell further, showing a continued flight to quality, as the FT notes. On Monday morning, the T-bill yield fell more than 120bp, to 2.53 per cent. Usually it stays close to the Fed Funds rate, which stayed at 5.25 per cent, says Authers:
This is the sharpest move in T-bills in decades, dwarfing anything from the tech bubble, or even the Black Monday crash of October 1987. Then, investors fled stocks and piled into T-bills.
This time, shares are rising, and there is only one conclusion, according to Authers: “Despite the Fed’s move, the loss of confidence in asset-backed loans and bonds appears greater than the loss of confidence in stocks in October 1987″.
