Markets Rally as U.S. Federal Reserve Leads Bold Liquidity Move

Bold Move

Recent weeks have seen almost unremitting gloom on the equity markets as companies batten down the hatches and the financial sector continues to reel. Investors have charged into commodities and other "safer" bets. The mood abruptly lightened yesterday when the Federal Reserve managed a positive surprise with its boldest liquidity injection to date. The Fed announced an expansion of its securities lending programme with a new term securities lending facility (TSLF). This sees the Federal Reserve lend up to US$200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing programme) by a pledge of other securities, including federal agency debt and residential mortgage-backed securities (MBS), as well as non-agency AAA/Aaa-rated, private-label residential MBS. The TSLF is intended to promote liquidity in the financing markets for Treasury and other collateral, and thus to foster the functioning of financial markets more generally. As is the case with the current securities lending programme, securities will be made available through an auction process. Auctions will be held on a weekly basis, beginning on 27 March 2008. This adds to the Fed's recent move to increase the volume of funds available to the banking system through the term auction facilities (TAFs), and expanded the volume of funds and terms available on open-market repurchases.

Yesterday's move is intended to address further distress in the functioning of the financial markets, particularly the MBS market. Due to the ongoing recession in the housing market, and accelerating declines in home prices, the valuation of mortgage-backed securities continues to come under downward pressure. This pressure had already led to about US$150 billion in gross write-offs in the financial system in 2007 (about 15% of banking system capital), but recently this problem has escalated to engulf the mortgage-backed securities of the highest-rated government-sponsored enterprise (GSE)—that is, Fannie Mae, Freddie Mac, and Ginnie Mae. Prices on these securities have dropped sharply in the past week, while yields have spiked. At the end of 2007, there were about US$4.443 trillion of these GSE mortgage-backed securities outstanding in pools in financial markets, with about US$700 billion of that total held in the domestic commercial banking system, and another US$700 billion held on balance sheets at the GSEs themselves. A significant chunk of these pools are also held in overseas banks, central banks, and sovereign wealth funds. With the value of these securities now coming under substantial downward pressure, not only does this pose another potential threat to capital levels in the banking system, but investors in general are shunning these securities as a result of further potential mark-to-market write-downs. This has led to the emergence of feedback loops, with significant negative effects for the functioning of the financial markets. With this new action announced yesterday, the Fed is launching a full-scale assault to substantially defuse these feedback loops.

International Co-Operation

In addition, the Fed yesterday announced increases in its existing temporary reciprocal currency arrangements (swap lines) with the European Central Bank (ECB) and the Swiss National Bank (SNB). These arrangements will now provide dollars in amounts up to US$30 billion and US$6 billion, respectively, to the ECB and the SNB, representing increases of US$10 billion and US$2 billion. The Federal Open Market Committee (FOMC) extended the term of these swap lines through to 30 September 2008. This represents an expansion of the currency swap agreements announced with the same central banks in December 2007. The expansion of the currency swap agreements comes in response to further pressure on U.S.-dollar funding costs and U.S.-dollar liquidity for banks outside the United States, particularly the banks in Europe. As neither the Swiss National Bank nor the European Central Bank can supply U.S. dollars to the European banks under normal central bank operating conditions, the currency swap agreements are temporary facilities that allow them to provide U.S.-dollar funds directly to the European banks, and hence alleviate the U.S.-dollar funding pressures that have intensified in European markets.

Markets Cheer

The two-pronged announcement helped the Dow Jones Industrial Average (DJIA) gain 3.6% over the day to close at 12,156.81, while the S&P 500 was up 3.7% to 1,320.63. This was the DJIA's best day since March 2003, and they have been followed by similar rises in Asia and Europe. The only market in Asia not to rise today was China, and the overall MSCI Asia Pacific Index put on 1.7%. In Europe, the pan-European TSE Eurofirst 300 Index added 1.2% yesterday, and has continued to gain at the time of writing today. Banks have predictably posted some of the strongest gains, albeit from a low base. As investors' interest in equities was rekindled, the unrelenting commodity gains paused for breath. Oil prices backed off their latest all-time record of close to US$110 p/b. The U.S. dollar briefly rebounded from record lows against the yen and euro, but then fell back once more. It is being weighed down partly by concerns that Gulf central bankers could abandon their dollar pegs next week.

Outlook and Implications

Yesterday's initiatives are just the latest in an ongoing, multi-pronged strategy to combat severe pressures in the financial markets and intensifying recessionary pressures across the economy. The Fed is also expected to lower interest rates aggressively in the next couple of months. Global Insight is forecasting that the FOMC will reduce the federal funds rate by at least 50 basis points on 18 March, and by a further 50 basis points in April and June. That would bring the funds rate down to 2.00% by the July-August time-frame.

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