Markets again look to Fed for relief
Wall Street moved close to the precipice this week, only to be pulled back by renewed faith that the government can fix what ails the financial system.
That faith had ebbed away in November, and it’s an encouraging sign that investors are willing to give it another shot -- because it has become increasingly clear that the financial system isn’t likely to fix itself.
Federal Reserve Vice Chairman Donald L. Kohn on Wednesday spurred the biggest gain in the Dow Jones industrial average since mid-September with a strong hint of another interest-rate cut when the central bank meets Dec. 11.
That message was echoed by Fed Chairman Ben S. Bernanke on Thursday evening.
Also on Thursday, Treasury Secretary Henry M. Paulson Jr. met with major housing lenders about a plan to freeze mortgage costs for some subset of homeowners with adjustable-rate loans.
All told, the news from Tuesday through Friday was upbeat enough for blue-chip stock indexes to recoup about half of what they had lost in the previous seven weeks. The Dow Jones industrial average finished the week at 13,371.72.
For the bulls, help came none too soon. At their closing levels Monday, major stock indexes were down more than 10% from their recent highs, the sharpest pullback in more than four years. Ten-percent drops don’t necessarily turn into bear markets, but they’re the first big step if you’re going there.
The overriding fear that has rocked stock and bond markets since mid-July is that soaring mortgage defaults and sinking home prices would drag down the economy overall.
The direct effect on struggling homeowners is bad enough. The indirect effect of the housing debacle has been a partial paralysis of the financial system worldwide. That paralysis took hold in August, eased in September and October, then worsened again last month.
As many banks, brokerages and other lenders have suffered huge losses on mortgages and related debt, some financial institutions have become reluctant to lend to others -- despite the efforts of the Fed and other central banks to keep money flowing.
No one wants to be on the hook to someone else who might be facing financial ruin. Self-preservation has become paramount.
The Fed and other central banks “haven’t been able to overcome a lack of trust” in the financial system, said T.J. Marta, fixed-income strategist at RBC Capital Markets in New York.
“I think we’ve only begun to realize how devastated the system is,” he said.
With globalization, extraordinarily complex U.S. mortgage-backed securities now reside in portfolios worldwide. Losses continue to emerge in unexpected places -- this week, for instance, in a Japanese agricultural bank and an Oslo brokerage.
What’s more, with the rise of hedge funds and so-called structured investment vehicles that loaded up on dicey mortgage debt, “we have a quasi-banking system built around the banking system,” said Dan Fuss, a veteran bond fund manager at Loomis Sayles & Co. in Boston.
That has made it more difficult for investors, and regulators, to get a handle on the size of the threat they’re facing.
Investors’ extreme fear level has been evident in the rush into Treasury securities as a haven in recent weeks, driving yields to multiyear lows. It’s the old line: Return of capital has become more important than return on capital.
Even as the stock market rebounded this week, there were more signs that the credit markets remained on edge. On Thursday, a Florida state investment fund that pooled the cash of local governments was forced to freeze withdrawals because too many of the investors were trying to pull out, concerned about potential losses on mortgage-related short-term IOUs.
So, confidence in the nation’s financial infrastructure remains in short supply. That’s the disturbing picture the Fed faces as it prepares for its Dec. 11 meeting.
Some Fed officials made clear in the last month that they hoped they had already done enough, with a half-point cut in their benchmark short-term rate on Sept. 18 and a quarter-point cut, to 4.5%, on Oct. 31.
One argument repeatedly put forth was that the real economy was holding up despite the jitters in the financial system. Although economic growth has slowed it hasn’t fallen off a cliff.
Nonetheless, “if you let the capital markets melt down the economy will follow,” said Ethan Harris, an economist at brokerage Lehman Bros.
Kohn and Bernanke this week both indicated that they understood the threat.
Bernanke specifically cited “a further tightening of financial conditions” as a growing risk to economic growth.
Interestingly, that chorus was joined Friday by another Fed official who previously had been sounding unsympathetic to the idea of more rate cuts.
William Poole, president of the Fed’s St. Louis bank, has been one of the most vocal central bankers in warning that the Fed shouldn’t ease credit just because the stock and bond markets are pleading for it.
In a speech Friday, Poole’s tone changed. The Fed “should not sit by while a financial upset becomes a financial calamity affecting the entire economy,” he said.
Of course, policymakers can’t know whether another rate cut, or five more, will be enough to restore faith in the credit markets or keep the economy from falling into recession. Stock bargain hunters, be careful.
Likewise, the Treasury-supported proposal for mortgage lenders to freeze interest rates for many adjustable-rate borrowers could be very difficult to implement on a large scale. It may not work at all.
For the moment, Wall Street is simply relieved that the Fed and the Treasury are taking leadership roles in trying to get the financial system out of the mess it’s in.
Because, well, there’s really no one else to do it.
