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With money markets still in distress, cut in interest rates is expected

Section: Daily Dispatches

Jitters Hint at Further Intervention

By John Authers
Financial Times, London
Friday, August 24, 2007

A week after the US Federal Reserve's decision to cut the rate at which it lends to banks, the move has yet to achieve its purpose of reviving global money markets.

Instead, the cut in the Fed's discount rate was followed by the most extreme panic in short-term money markets since, at least, the "Black Monday" stock market crash of October 1987.

The money markets spent the rest of the week slowly recovering, but by Friday the difficulties for many companies in raising short-term financing remained acute.

These difficulties, in turn, strengthened the belief that the central bank would be forced to intervene further by cutting the main Fed funds rate, at which banks lend to each other.

The market in Fed funds futures, which investors use to hedge against moves in the Fed funds rate, signalled throughout the week that such a cut was a certainty, and that a reduction from the current 5.25 per cent to 4.5 per cent was overwhelmingly likely by the end of the year.

The crisis of confidence in the money markets was most plainly visible in the prices of short-term Treasury bills, which are regarded as the safest and most liquid investments in the global financial system.

When investors lose confidence in other assets, they pile into T-bills in what is known as a "flight to quality." This pushes up the T-bills' price and pushes down the yield they pay.

Normally, T-bill yields scarcely vary from the Fed funds rate. But at the time the Fed cut its discount rate last week, three-month T-bills were yielding only 3.8 per cent.

The flight to quality continued, despite the Fed's action, and reached extreme levels on Monday, when the three-month T-bill briefly yielded less than 3 per cent, while four-week T-bills yielded less than 2 per cent.

They have recovered since then, but three-month yields rose above 4 per cent only on Friday morning -- still just slightly up from when the Fed intervened.

"Although some signs of normalisation have emerged, it remains clear that we are a very long way from normality," said Charles Diebel, fixed-income strategist at Nomura International. But he added: "All the signs are that we have seen a temporary lull and that further distress is in the pipeline."

The greatest problem is in asset-backed commercial paper, used by large companies to raise short-term funds, usually at a rate that varies only slightly from the Fed funds rate.

Investors, particularly money-market fund managers, have been worried that the collateral for the commercial paper might be contaminated by bad subprime mortgage bonds. When financing could be raised this way over the past week, it was at rates of about 6 per cent.

The amount of money raised through asset-backed commercial paper dropped by $77 billion last week, while issuers resorted to borrowing over ever-shorter terms. This suggested that the problems in this market were worsening.

Stock markets, meanwhile, remained mostly only 5-6 per cent below their peaks, and still in positive territory for the year. They were buoyed by hopes of rate cuts, and by evidence that corporate profitability remained strong in the second quarter. According to Thomson Financial, profits for S&P 500 companies rose by an average of 8.1 per cent in the second quarter -- far more than the 4.1 per cent that had been forecast at the beginning of last month.

Other signs of risk aversion abated slightly as the week progressed, but remained very high.

The Chicago Board Options Exchange's Vix index, also known as Wall Street's "worry gauge" -- which derives equity market volatility from the price of options on the S&P 500 -- fell over the week to 21 after reaching 37.5 at one point last week. But it remains at a higher level than at any point since the invasion of Iraq in March 2003, and shows that stock investors remain very much on edge.

Apart from the Fed, market worries centred on hedge funds. It is known that several large quantitative hedge funds suffered severe losses in the first week of August, and speculation turned to where losses would show up next. There was also gossip that some of the large private equity buyouts that have yet to be financed may need to be renegotiated. This would have a very negative impact on confidence in the stock market.

Traders said it would be hard for money markets to revive until uncertainty had been removed over the extent of subprime losses and of the contagion to losses elsewhere in the financial system. That will take time.

Marco Annunziata, chief economist at UniCredit in London, said: "The main lesson of the past week is that, unless and until the 'information crunch' can be eased, financial markets will not stabilise."

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