Wednesday, October 8, 2008

Can We Escape This Financial Black Hole?

Major central banks launched an exceptional joint effort to battle the global financial crisis today, simultaneously slashing interest rates on three continents in a move aimed at rescuing the flagging global economy.

But the coordinated response from the world's central banks failed to reassure global stock markets:

The Dow Jones industrials average ended down 189 points, after falling 316 points in the final 28 minutes of the session.

The broader market finished down 1.1 percent, a modest decline compared to the rest of the week, as measured by the Standard & Poor's 500-stock index.

"It just feels like more of the same," said Richard Sparks, an analyst at Schaeffer's Investment Research. "This is an extremely weak market with a tremendous amount of uncertainty."

The Asian markets opened mixed Thursday, showing that concerted international interest rate cuts announced overnight failed to entirely dispel fears of a global downturn that would also affect the region.

The Nikkei 225 stock average rose 0.1 percent to 9,910 soon after the open, after falling 9.4 percent on Wednesday, in its biggest one-day fall in 21 years.

However, in Australia, the Standard and Poor's/Australian Stock Exchange 200 index extended the previous days' losses, falling another 1.8 per cent.

Stocks were volatile in Europe and the United States through much of Wednesday, lurching up and down the chart across a 400-point range.

Investors had appeared conflicted about the extraordinary global rate cut by the world's central banks that came before trading opened in New York. Stocks ducked in and out of positive territory as investors weighed the good — a half-point reduction in the Federal Reserve's benchmark interest rate — against the bad, namely the growing realization that a serious recession may be difficult to avoid.

"The Fed, worldwide government agencies and central banks have done just about anything they can now," Sparks said. "And that may be the biggest fear now. They've used up all their bullets and there's really nothing left to do other than let it work its way through the system."


"Rate cuts, federal funds cuts, are not going to be enough," at a time when banks are reluctant to lend to one another, Genberg said, adding that considerable academic research suggests that the United States must find a way to restore the capital bases of its banks.

One economist who feels that the rate cuts will do little to stem more losses is NYU professor Nouriel Roubini.

Roubini predicted this disaster a long time ago and he was on Tech Ticker today discussing his views on stocks and the global economy. You can click here to view all his comments.

Here are some of Roubini's thoughts:

The coordinated global rate cuts have reduced the risk of a market crash, but won't resolve the underlying crisis. The central banks should have cut at least 100 basis points, Roubini says. World governments should also immediately band together and put together a comprehensive plan:

  • Guarantee all bank deposits temporarily (not just up to $250,000, and not just in the United States).
  • Triage the banking system by recapitalizing survivors with equity injections and letting the rest die.
  • Get ahead of the crisis instead of looking panicky and reactive; failure to do so continues to undermine confidence.

Roubini's best-case scenario? “At this point, the recession train has left the station. The financial and banking crisis has left the station. We’re going to have a severe recession. We’re going to have a severe financial crisis. What we can avoid is a systemic collapse of the financial system.

And the corporate sector is going to lead us to something close to the Great Depression or to what happened to Japan, with a stagnation of economic growth for a decade. So at this point, it’s going to be ugly regardless, but at this point we can avoid a total meltdown of the system and a multi-year collapse of the global economy.”

The financial market crisis has unfolded even quicker than Roubini expected (which is saying something), and the economist now thinks the Dow and S&P will suffer 50% declines from last October's peak vs. 40% previously.

In other words, the Dow is going to 7,000, but over the course of months vs. days if Roubini is right, as -- unfortunately for bulls -- he mostly has been for the past two years.

"The policy response is going to become more aggressive [but] a steady flow of bad financial and macro economic news is going to push down equity markets," he says, forecasting a real bottom won't be hit until "sometime next year."

Because of growing slack in the global economy, Roubini says deflation is going to become a much bigger threat in the next six months vs. inflation. In such an environment, cash, Treasuries and gold are the only safe bets he says -- provided your holdings are within the FDIC's new $250,000 insurance cap.

The dramatic meltdown of the financial markets has shifted focus from the real economy, which Roubini says is where the downturn is truly being felt. he notes that the $700 billion bailout and today's global rate cuts may have helped avert a complete financial collapse.

But the recession -- which he says began in Q1 of this year -- is deepening and will last into early 2010.

Retail and personal spending fell sharply over the summer, marking a drop in consumption for the first time since 1991 -- and the Q3 numbers are only going to be worse, says Roubini. Moreover, corporate capital spending is down, which will translate into even fewer jobs in the coming months.

Roubini adds: "I worry that it'll be worse than I expected," in which he predicts a slow, possibly L-shaped recovery a la Japan.

I believe that Roubini should be commended for the courage he displayed in exposing this disaster a long time ago when people were dismissing him.

I also worry that it will be worse than he expects. As hedge fund redemptions lead funds to unload stocks, it increasingly looks like markets are reeling from massive liquidation where hedge funds and traders are selling equities to make margin calls. This is why every rally is met with fierce selling. This can become a vicious cycle.

As if hedge-fund managers haven't felt enough pain lately, now the U.S. government is cracking down on them.

Tucked away inside the recent $700 billion U.S. plan to buy toxic mortgage assets are unrelated changes to the tax code -- effectively eliminating a favorite tax-deferral dodge of hedgies.

In response, hedge fund investors are asking for lock-ups to avoid closures and top hedge funds are reopening to new investors.

But this market crash is unlike anything we have ever seen before. It is relentless and the only thing that might signal some sort of short-term bottom is that fear - as gauged by the volatility index (VIX) - is reaching record levels:
"I see this volatility as a good sign we're approaching the end,'' said Barry James, president of James Investment Research Inc., which manages $2 billion in Xenia, Ohio. ``It's pure fear right now and that's the best time to buy.''
This might be a good time to buy, but it isn't the "capitulation bottom" which we typically see when markets truly bottom and the VIX explodes up. This, however, does not mean that a powerful bear market rally can't develop from here if the wave of indiscriminate selling is exhausted in the near term.

And what should policymakers do to fix this mess? For this, I refer you to Paul Krugman's blog entry, To do, not to do as well as Greg Mankiw's blog entry, How to Recapitalize the Financial System.

Finally, let me take the time to extend my best wishes to Jews celebrating Yom Kippur, the holiest day of their year.

***Note on the Canada Pension Plan Investment Board

The Canadian Press reports the Canada Pension Plan Investment Board (CPPIB) says the CPP is secure amid a financial crisis that threatens the Canadian economy:
The CPP board says the fund is designed to withstand the kinds of short-term market fluctuations that trouble many Canadian investors.

It says the fund was sheltered from the U.S. credit crisis because it had no exposure to sub-prime mortgages when cracks began to show in August 2007.

But a board spokesman declined to say whether recent volatility on the stock markets has ebbed away the fund's assets.

The board is an arm's-length agency that invests the funds not needed by the Canada Pension Plan to pay current benefits.

The CPP's assets totalled $127.7 billion during quarter ending June 30 - a one per cent investment rate return over the previous quarter.

Just between you and me, there is no way CPPIB is not exposed to this credit crisis, which started in the subprime area but quickly spread to other sectors.

All pension funds will get slaughtered in 2008 and 2009 primarily because global equity indexes are down anywhere between 30% to 60%.

***Morning update:

It looks like stocks will open higher this morning based on IBM's better than expected results, but the credit markets remain a concern as Libor rates jumped to the highest level in a year:

``To see little or no reaction in the fixings is very disappointing and reinforces the fact that Libor is broken and the transmission mechanism from central banks isn't working,'' said Barry Moran, a currency trader in Dublin at Bank of Ireland, the country's second-biggest bank. ``Things are still very stressed and we don't know what's going to fix it.''

The London interbank offered rate, or Libor, for three-month loans rose to 4.75 percent today, the highest level since Dec. 28. The Libor-OIS spread, a measure of cash scarcity, widened to a record. The overnight rate fell to 5.09 percent, still 359 basis points more than the Fed's 1.5 percent target rate.


South Korea, Taiwan and Hong Kong cut interest rates today, a day after reductions by central banks including the Federal Reserve and European Central Bank that were designed to stem damage from the global financial crisis. The U.K. government pledged yesterday to spend 50 billion pounds ($87 billion) to stave off a collapse of the British banking system.

``I don't see a wave of liquidity coming into the market,'' said Alessandro Tentori, an interest-rate strategist in London at BNP Paribas SA. ``People are still holding on to their cash because there's still a great deal of uncertainty out there.''


``Libor spreads are still wide, which suggest offshore banks are not willing to take more risks lending to other banks,'' said Cezar Bayonito, a liquidity trader at Allied Banking Corp. in the Philippines. ``Interest-rate cuts will be of little help in the near term because the issue is trust, not rates.''

Libor, set by 16 banks in a daily survey by the British Bankers' Association at about noon in London, determines rates on $360 trillion of financial products worldwide, from home loans to derivatives. Member banks provide estimates on how much it would cost to borrow in 10 currencies for periods ranging from a day to a year.

Overnight rates on dealer-placed commercial paper rose 56 basis points to 3.5 percent yesterday, while investors seeking a haven for their money pushed the yield on three-month Treasury bills down 15 basis points to 0.6 percent. Bill yields rose 4 basis points today to 0.66 percent.

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