The Fed Phenomenon
By Stephen Smith
November 6th, 2007
In my last Market Insights, I tried to explain what was happening in the credit markets. I briefly talked about how the Federal Reserve and central banks globally have pumped massive amounts of liquidity into the system. These banks allow primary dealers, i.e., large banks and broker dealers to pledge assets and borrow money in the hope that they will then lend to other institutions. A problem arose when these primary dealers borrowed the money but then did not lend to other businesses or institutions because of all the problems in the derivative and sub-prime mortgage markets. In response to this dilemma, on August 17, 2007, the Federal Reserve cut the discount loan rate by one-half percentage point from 6.25 percent to 5.75 percent. This dramatic move by the Fed was designed to ease the severe cash crunch facing many businesses, including mortgage companies, which were having trouble getting loans for short-term financing needs.
The action seemed to calm the financial markets, but the credit markets remained extremely volatile. Normally, the one month LIBOR rate (London Inter Bank Offered Rate) has a very high correlation (.99) to the fed funds rate. The LIBOR rate is a universally accepted, both domestically and inter-nationally, benchmark borrowing rate. It is an index used on everything from the smallest adjustable rate residential mortgage in the United States to the largest international corporate line of credit. The LIBOR rates are not administered, but set in the market by supply and demand. However, because of the close substitution effect associated with the fed funds rate, LIBOR has a tendency to follow the fed funds rate. Because of the issues associated with the turmoil in the derivatives and sub-prime mortgage markets, the LIBOR rate continued to increase instead of decrease and was over one percentage point above the fed funds rate. Corporate borrowing costs skyrocketed and many businesses were having difficulty even finding funding.
On September 18, 2007, the Federal Reserve cut the fed funds rate by one-half percentage point from 5.25 percent to 4.75 percent and cut the discount rate by one-half percentage point to 5.25 percent. This was the first rate cut in the fed funds rate since June of 2003 and the first half point cut since November 2002. In its statement, the Federal Reserve said that “the tightening of the credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally and the rate cut is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in the financial markets and to promote moderate growth over time.” Most economists and investors, me included, thought Federal Reserve Chairman Ben Bernanke would take a more cautious approach and not cut the rates by such a large margin. Many felt that a quarter percentage rate cut would be appropriate, because there was not data showing that the credit crisis was moving to the broader economy. The financial markets, however, cheered the Federal Reserve’s move. Stocks surged—the Dow Jones Industrial Average finished the day up 2.5 percent, the Nasdaq gained 2.7 percent, and the S&P 500 gained nearly 3 percent. The credit markets have moderated, but investors should not assume that the problems are over. The Federal Reserve’s actions are important, but they do not put to rest the fears that emanated from the credit crisis.
Volatility in the market is not a new phenomenon, and for the patient investor, it can create opportunity. We know over the long term that prudent investment management rewards investors for their patience. We thank you for yours and the confidence you have placed in us.
