Thursday, October 30, 2008

Never Mind the Fed — Watch Libor

(WSJ MarketBeat) Forget about the Fed. What needs to be watched in coming weeks is Libor, if you’re looking for cues on the direction for equities in coming days and weeks.

Some believe rate decisions from the Fed no longer carry the paramount importance they once did for markets because the link between that target and what banks actually charge one another has broken down to some extent.

Other measures, including the distressed asset repurchase program and the Treasury Department’s bank bailout, are just as important as rate policy, said Zach Pandl, economist at Barclays. For a sign that those liquidity efforts are taking effect, watch the London Interbank Overnight Rate, or Libor, rate, he said. “That’s the canary in the coal mine,” Mr. Pandl said.

The overnight dollar Libor rate fell to 0.73% from 1.14% Wednesday, below the then-Fed target rate. The spread between the federal-funds rate and the three-month interbank lending rate fell to 2.46 percentage points from 2.58 percentage points Wednesday, still quite elevated. For a sign that bank lending is returning to “normal,” Mr. Pandl said, the three-month spread would have to narrow to 12 to 15 points.
The three-month rate remains “stubbornly high,” and banks demand for money relative to supply remains tight, said Stephen Gallagher, an economist at Societe Generale. And until the spread narrows, Mr. Pandl said, rate cuts won’t have any traction to assist the economy. That’s because the availability and cost of loans to corporations and consumers depends on the interbank lending rates.

On Tuesday, Sept. 17, stocks rallied despite the Fed’s unexpected decision to leave its target overnight lending rate unchanged. This time, stocks bounced around the flat line even as the Fed cut rates.

Since the failure of Lehman Brothers Holdings Inc. (LEHMQ) in mid-September, the Fed has flooded markets with liquidity, but that hasn’t pushed banks to increase lending significantly, Mr. Gallagher said. The commercial paper market has begun to respond to action from the Federal Reserve, as the total amount of commercial paper outstanding increased by $100.5 billion to $1.549 trillion for the week ended Wednesday, the first increase in seven weeks.

“A low fed-funds rate helps bank profitability to the point banks are willing to continuously refinance themselves, but the benefits to the economy are muted,” he wrote.

However, there are disagreements as to the efficacy of these moves — whether the improvements in commercial paper and Libor rates truly reflect an improvement in underlying credit conditions, or not much more than a propping-up by the authorities. “To argue that the credit crisis is easing because government-controlled interest rates are falling is to argue that inflation is abating because the government-controlled target funds rate was getting cut,” writes James Bianco, president of Bianco Research LLC. “It is true that some companies have gone from no access to in the commercial paper market to a government subsidy. Why is this a sign things are getting better?”

The other reason traders aren’t swayed by the Fed’s U.S. policy: the global nature of markets and economic activity. To that end, the Fed also unveiled a program to cooperate with Brazil, Singapore, Mexico and South Korea by establishing “swap lines.” Signals from the Bank of Japan and the European Central Bank that they will follow the Fed’s moves cheered stock markets overseas, which featured a 10% rally in the Nikkei.

One trader said it was significant that the Fed highlighted the coordinated interest-rate cuts worldwide. Even the Fed is taking a global view, said Craig Peckham, head of equity trading at Jefferies, who will watch the actions at the European Central Bank and other central banks worldwide.

Commercial paper rates have snapped back, but some wonder whether this would have happened without government support. (Source: Federal Reserve)

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