Tuesday, September 16, 2008

Stocks rise as Fed keeps interest rates steady, pumps $70 billion in financial system

There is a lot of news coming out on the financial markets today. I'm going to start with the stock market news, where the Dow gained 140 points today:

NEW YORK - Wall Street ended another tumultuous session with a sizable gain Tuesday, partly recovering from its worst sell-off in years after the Federal Reserve said it was keeping interest rates steady. The central bank soothed fears of a worsening financial crisis even as the market waited to learn the fate of troubled insurer American International Group Inc.

In a statement accompanying its decision, the Fed noted the growing strains in the financial markets a day after the Dow Jones industrials plunged 504 points in reaction to continuing turmoil in the financial sector. The Fed also noted the ongoing weakening of the labor market. But it also sought to give some reassurance by saying it expected its policy moves to foster moderate economic growth over time.

The Fed has cut its target federal funds rate by 3.25 percentage points to its current level of 2 percent over the past year. Many on Wall Street expected the Fed to keep rates steady but there was some hope that the central bank would try to calm uneasy financial markets with a rate cut.

According to preliminary calculations, the Dow rose 141.51, or 1.30 percent, to 11,059.02, after falling about 100 points immediately after the Fed announcement. The Dow at turns rose and fell as much as 175 points in fractious trading; on Monday, it suffered its largest drop since the September 2001 terror attacks.

Broader stock indicators advanced. The Standard & Poor’s 500 index rose 20.90, or 1.75 percent, to 1,213.60, and the Nasdaq composite index rose 27.99, or 1.28 percent, to 2,207.90.

Dow Jones one week chart. From NY Times

Wall Street traders were hoping for any good news to come today, after the weekend worries of Lehman Brothers bankruptcy, Merrill Lynch's sale to Bank of America, and AIG's continued deteriorating financial condition. The wet dream for Wall Street was a potential Federal Reserve rate cut, however the Fed decided to keep the rate as is. In keeping interest rates as they were, Wall Street decided that was good enough news for today.

And there was more good enough news to provide something of a Wall Street rally. The Federal Reserve pumped $70 billion into the financial system today:

WASHINGTON - Urgently trying to keep cash flowing amid a Wall Street meltdown, the Federal Reserve on Tuesday pumped another $70 billion into the U.S. financial system to help ease credit stresses.

Chart showing Federal Reserve benchmark for the year. From NY Times

The Federal Reserve Bank of New York's action came in two operations in which $50 billion and then another regularly scheduled $20 billion were injected in temporary reserves.

The cash infusion Tuesday was designed to help ease a spike in the overnight lending rate between banks. A sharp rise in such borrowing costs makes banks reluctant to lend to each other and to hoard cash, worsening already tight credit conditions. Harder-to-get credit has crimped spending by consumers and business, a factor in the slowing economy.


In the last few days, the American financial system has been badly shaken as bad bets on dodgy mortgage-backed securities claimed more Wall Street giants.


To help grease the financial plumbing Monday, the Fed pumped a total of $70 billion into the system through open market operations.

So, Wall Street was worried about the bad debt, and the derivative gambling taking place which have shaken Lehman Brothers, Merryll Lynch, and AIG. And there is certainly more worries that other banks and investment firms could get into trouble if they can't finance their derivative contracts, or their mortgage-backed securities. So this becomes another piece of good news for Wall Street traders to rally to stock market.

The problem here is that this is a short-term rally, in the face of a long-term problem. According to The New York Times, the Fed is caught in "an epic crisis of confidence in financial markets and stalling growth on the one hand, and persistent if less dramatic inflation pressures on the other." Investors reacted at first at the news of the Fed's leaving interest rates unchanged by sending the Dow down "by almost a full percentage point immediately after the announcement." But then traders decided this wasn't such bad news after all, since Wall Street was originally expecting the Fed to keep interest rates steady. The stock market was reacting jittery over any financial news, considering the crisis that has rocked Wall Street over the past weekend. This was a crisis in confidence. California State University, Channel Islands' economist Sun Won Sohn said, “The F.O.M.C. has decided to stand pat despite the market turmoil. “Lower interest rates at this time would not solve any problems in the financial markets. The market is not short of liquidity; it is short of confidence.”

And this lack of confidence will continue to roil the financial markets. Fed officials will be meeting in New York to determine the fate of American International Group, "which may need up to $75 billion to shore up its books." There is talk of a Fed-arranged loan package for AIG, but no one is commenting on such a proposal. The Federal Reserve faces "the uncomfortable fact that interest rates have little to do with a credit crisis that stems from staggering losses on poorly underwritten mortgages and mortgage-backed securities." AIG doesn't need a cut in the interest rate of their loans, AIG needs money to cover their losses stemming from the bad bets made on the subprime mortgage investments. According to the NY Times:

The unanimous decision surprised many analysts and investors, who had expected the Fed to bolster confidence with another flood of cheap money. But some economists said the decision reflected the unhappy truth that a cut in the overnight Federal funds rate might have merely highlighted the Fed’s limited ability to solve a problem that entails the entire housing and mortgage markets.

“The financial markets aren’t frozen because the Federal funds rate is too high,” said Michael Darda, chief economist at MKM Partners, an investment firm in Greenwich, Conn. “The markets are frozen because there is a crisis of confidence. It’s not a matter of whether the short rate is 2 percent or 1.5 percent.”

Below the surface, the Fed continued to flood the markets with extra cash through its open-market operations in New York. On Tuesday morning, the Fed injected an additional $50 billion into the markets simply to keep the Federal funds rate at its target level of 2 percent. The funds rate had climbed as high as 4 percent when markets opened.

This brings up another problem for the Federal Reserve. Look at how the markets reacted to the financial crisis in regards to the funds rate--it climbed as high as 4 percent when the markets opened. Banks are not willing to loan money out to financial firms facing problems with their balance sheets due to the bad sub-prime mortgage investments. After the credit agencies downgraded AIG's credit rating, AIG was forced to post collateral from $10-13 billion. It is not that there is no liquidity out there, but that banks are not handing out loans to institutions unless they have platinum-plated credit ratings. So instead of cutting the federal funds rate, the Fed has been pumping even more money into the financial system simply to keep the interest rates down to 2 percent, even as banks are refusing to release the money out into the market. If the Federal Reserve did not release the $50 billion into the financial market, money in the credit market would continue to dry up, sending interest rates even higher.

The day of reckoning is still coming.

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