Markets have had more than a week to digest the dramatic cut in the fed funds rate to 4.75 per cent. So, asks the FT’s John Authers in Friday’s Short View column, has it worked?
There are two entirely different answers, he concludes. From one perspective, it has stimulated equities. There are notes of caution – the main indices are not back to their highs, and defensive stocks have outperformed for the last week – but the cut has made stock investors a lot of money, he notes.
“Intriguingly, it has also made money for commodity investors,” he adds. 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, Authers reminds us. “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.”
To look at it in two ways: First, 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.
To look at it a second way, though: “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.