What's Next After Rate Cuts?
On 8 October 2008, the central banks of six of the most developed markets coordinated an unprecedented move to ease the economic effects of the credit freeze. The Federal Reserve Bank, European Central Bank, Bank of England, Sveriges Riksbank, Bank of Canada and Swiss National Bank simultaneously announced a cut in their benchmark lending rates by 50 basis points.
Apart from these six major central banks, central banks in emerging markets also took similar steps to solve this extraordinary financial crisis. In Asia, the People's Bank of China lowered its one-year benchmark lending rate by 27 basis points to 6.93% and suspended the tax on interest income. In the Middle East, Kuwait's central bank cut its benchmark interest rates aggressively by 125 basis points to 4.5% in an attempt to mitigate the effect of the liquidity crisis on its local financial sector while the U.A.E's central bank cut its benchmark repo rate by 50 basis points to 1.5%.
On 9 October 2008, one day after the coordinated rate cuts, the central banks of Taiwan, Korea and Hong Kong announced a cut in their benchmark rate. The Central Bank of the Republic of China cut its discount rate by 25 basis points to 3.25% while the Bank of Korea announced an interest rate cut of 25 basis points to 5% for the first time in 4 years. The Hong Kong Monetary Authority also reduced its base rate from 3.5% to 2%.
This is the first time central banks across the world have come together to support the financial markets since the outbreak of the financial crisis last year. We think that while the impact of the rate cuts is not spurring equity markets in the past week, with the S&P 500 index falling 3% and the MSCI Asia ex-Japan falling 8.7% from 8 October to 10 October 2008.
In this story, we provide two reasons why these heavy and unprecedented rate cuts did not immediately spur sentiment, in particular the first week of October 2008, and what we will likely see going forward that will spur markets on.
Rate Cuts Not Spurring Credit Markets, Spreads Still Widening
We believe that the psychological signal delivered by this coordinated action is more impactful than the actual action of cutting rates, primarily because it sends out a very clear message that policy makers across the world are willing to act together to restore confidence in the banking system. The positive news of central banks helping to boost lending by increasing market liquidity actually shows the seriousness of the financial crisis. It shows that the US financial crisis is now spreading from the US to Europe and emerging markets. Such coordinated rate cuts mean that the governments are now more willing to take a concerted effort to calm investors down - a positive development.
However, as banks are still reluctant to lend. The near term effect of the rate cuts would affect interest rate spreads much at this point of time.
During this tumultuous period, concerns over counterparties' default risk have increased, thereby refraining banks from lending money to their peers albeit having excess cash. As a result, credit markets have tightened significantly, causing the cost of borrowing in US dollars to jump. We believe that the objective of the rate cuts is to inject liquidity in order to lower the interbank rate.
However, restoring liquidity in the market is a challenging task the policy makers need to tackle as banks remained reluctant to lend despite these rate cuts. The Overnight London-Interbank Offered Rate (LIBOR) increased by 144bp from 7-8 October, marking an increase of more than 100 basis points within a day for two consecutive days.
Chart 1: TED Spread Widened After the Rate Cuts
Apart from that, the TED spread (Chart 1) which represents the difference between rates the US government and banks pay to borrow in dollars for three months. From 1 - 7 October 2008, the TED spread widened to more than 330 basis points. After the announcement of the coordinated rate cut, the TED widened further by 35 basis points to 391 basis points on 8 October. This shows that investors are still not convinced that these rate cuts (on top of the bailout packages) will spur the credit market.
Government Guarantees May Work Better Than Rate Cuts or Bailouts
Some investors may believe that a rate cut of 50 basis points is insufficient to stabilize the market. But the concerted rate cuts have significant implications. Banks and investors are still waiting for further measures or rescue plans to solve the problem. Gordon Brown, the UK Prime Minister, has announced a plan of 50 billion pounds (US$87 billion) to partly nationalize some British banks. This shows a credible commitment by the UK government to prevent failures of British banks and thus helps to restore confidence in the UK banking sector. Furthermore, the action taken by the UK government will have a more direct impact as compared to that of the US, which proposes to use up to $850 billion to buy financials' bad debts and mortgage-related assets.
Selling bad debts to the government does not necessarily guarantee the survival of the troubled banks. This is because the US has been facing difficulties in pricing the toxic assets, with debates on the "fair price" of these troubled assets going on. If the US government were to purchase these assets from the banks at a deep discount, the banks' balance sheets may look even worse than what they were prior to the purchase. Paulson, the US Treasury Secretary has hinted that the government may invest in banks as the next step in trying to resolve the deepening credit crisis.
We believe that these plans (including the coordinated rate cuts and the rescue package) are essential confidence boosters in the market. The US and the UK government have already shown a high level of commitment to solve the problem but there is just too much pessimism and lack of confidence in the credit markets.
The recent rally in the S&P 500, which rose 11.6% on 13 October (in USD terms) gives us a better indicator of what investors seek - a confidence booster from the government.
Confidence Must Be Rebuilt
Banks are running out of liquid assets and cash due to the huge write-downs and it is extremely difficult to get funding in the open market. Based on the poor response from banks after the rate cuts, we believe that a further aggressive rate cut by the central banks will not effectively solve the problem of illiquidity for a period of time. The fact that the root of the financial crisis is over-borrowing and excessive leveraging when borrowing costs were low may raise concerns that aggressive rate cuts will lead to over-borrowings again. Once the illiquidity problem is solved, we believe that the central banks will start to tighten their monetary policy again. Thus, in the near term, if rates were cut or capital is injected but confidence on the credit market is not restored there would be little potential for confidence to be injected into the markets.
After the outbreak of the subprime crisis, banks have turned too conservative, resorting to holding more cash and liquid assets lest any further write-downs. However, cash is very much required in investment activities. The reluctance of banks to lend to each other or to other institutions or consumers will have a huge negative impact on economic activities as the financial sector is vital to the survival of an economy.
The issue that the financial sector is facing now is the lack of comfort and confidence in lending monies. And the central banks can seek to resolve these through measures are directly spurring confidence rather than simply injecting liquidity or cutting rates. Thus, if the US government can take up the measure of providing guarantees to deposits or even interbank borrowings (which actually can be quite a massive exercise), we think that this probably would help to inject more confidence into credit markets.
Since the end of last week, governments, led by the Federal Reserve, plan to buy stakes in banks. We will monitor the situation and respond in upcoming articles.
Eddy Wong is part of the Research Team at iFAST Financial Pte Ltd.
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