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THE STOCK MARKET STAGED an impressive recovery from steep early losses Tuesday, but was it a case of the symptoms being relieved while the underlying cause of the malady remains?
Reports that North Korea had put its military on alert last week supposedly in preparation for a confrontation with the South over the North's alleged sinking of a South Korean only served to upset markets already anxious about the European debt situation.
The latter was encapsulated in a single interest rate, three-month Libor, or the London interbank offered rate. This money market benchmark continued its upward creep, rising another three basis points (.03 percentage points) and a total of seven basis points over the past five trading sessions.
That sounds trivial, but in percentage terms that's significant, given the rise brought Libor to 0.53625%. That's roughly double Libor's level early in the year and the highest since early 2009, when the worst of the credit crisis was fading. Remember that the federal funds target set by the Federal Reserve has remained unchanged throughout at 0-0.25%.
The widening in the spread between the Fed-set overnight funds rate and three-month Libor, which is set by a survey of major international banks by the British Bankers Association at late morning in London, reflects the higher rates that some European banks are having to pay. The money market is demanding a premium from banks, especially those that own lots of bonds from the weak-credit governments of Greece, Portugal, Spain, Ireland and Italy.
The stock market began to recover by late morning on the East Coast. Helping to lift confidence was the declaration by Rep. Barney Frank that the proposal to restrict banks' derivatives activities "goes too far." The Massachusetts Democrat who will be the House of Representatives' lead negotiator in the House-Senate conference committee that will hammer out differences in the two chambers' financial-reform bills, so his say carries a lot of weight.
Frank's statement, plus the lack of any moves on the Korean peninsula, helped lift the pall on the market and especially financials. By the close, stocks had erased virtually all of their early, steep losses with the S&P 500 just fractionally in the plus side after 2%-plus opening losses. The Financial Select SPDR (ticker: XLF), the popular exchange-traded fund that tracks financial stocks, swung 4.5% from its early low to its closing high and ended with a net gain of 0.9% for the session.
While financial stocks recovered, the underlying problems in the money markets remain. That's important because the Great Credit Crash of 2008 and the subsequent bailouts were the result of the breakdown in the money markets, where finance and commerce are routinely funded. It's been likened to the plumbing of the economic system in that we are totally dependent upon but we don't think about it -- until it doesn't work.
It's unlikely that monetary authorities would stand aside and let another accident take place. In reaction to the upward creep in Libor, Michael Darda, MKM Partners chief economist and strategist, told clients the Fed may be on the verge of cutting the 100 basis-point penalty rate on its swap lines with foreign central banks. The swap facility is designed to provide dollars to other central banks, which can lend those dollars to the banks in its charge.
Darda pointed out that, despite the sharp expansion in the balance sheet of the European Central Bank, the broad money supply of the eurozone is shrinking while its turnover (velocity) has declined. Money times velocity equals gross domestic product; so if money and velocity are dropping, GDP must necessarily do the same. Without growing GDP, attempts to reduce fiscal deficits in the eurozone may prove futile, Darda writes in a note to clients.
The Fed and the ECB won't stand idly by and permit monetary contraction to subvert the vitally needed fiscal adjustments required among the weak countries of eurozone. Against that background, it's almost comical that back in the U.S., three regional Fed district banks actually requested an increase in the discount rate, according to a Fed document released Tuesday. While such a move would have little practical relevance, the effect of the announcement of a discount rate hike would be far stronger as in terms of what the markets might infer about the Fed's future moves.
So far, the problems of illiquidity in the money markets are "contained," to borrow a phrase that described the status of subprime mortgages in 2007 and 2008. If so, Libor ought to come back down closer to the Fed funds range. Conversely, a continued upward creep in Libor would indicate the fundamental problems remain.
Comments: randall.forsyth@barrons.com
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