A week of panic

Escrito el 25 Enero 2008 por Juan Toro en Financial Markets

I believe you all have seen what has been going on in the markets and everyone is pretty puzzled about the swings. Last week ended with the fiscal proposal by Bush to stimulate the economy (investment deductions and rebates) in an attempt to boost the economy and avoid a recession. This seemed good news for the market. But just before the Friday closing of markets in the US , news appeared claiming that rating assessment on monoline firms (such as AMBAC and MBIA) could be downgraded. This monoline firms are bond insurers. The book value of the bond portfolio of many banks depend heavily on the financial muscle of these companies. So revisions on the credit quality of monoline companies would imply further write downs by banks and more financial distress.

Monday this week was a US holiday, and hence markets were relatively thin. Markets woke up with a run on stocks and most equity indices suffered heavy losses. Ex post this has been justified on the liquidation of a big losing position by French Bank (Soc Gen). The rogue trader who lost 5 billion dollars. This is probably too extreme of an explanation and other factors were moving markets on that direction.

Tuesday, the Fed came into the rescue of the stock market and the Bernanke put was born. The Fed unexpectedly brought down rates by 75 basis points. That was a big movement and we have to go as far 1984 to find a similar cut off meeting. But even at that time rates were much higher than they are today. So in relative terms, Tuesday move was a considerable one. According to this Bernanke put if markets shoot down, Bernake will always come into its rescue with rate cuts. This action did not calm the market but contrary to expectations, market became more nervous and start pricing a further 50 basis point in the meeting of the 30th of January (just one week later). Even more strange, market were pricing off meeting cuts in February. That was looking like an extreme dynamics. On the other side of the Atlantic, the bank of England claimed they would not act out of scheduled meetings and the European Central Bank (ECB) was hawkish on the inflationary scenario. Remember that the Fed and the ECB have different mandates. The ECB safeguards just inflation whereas the Fed is responsible for both the value of money and the level of activity. These statements did not help markets that were looking for a Trichet put.

Wednesday things were not any better. There were evidences that the famous decoupling story was just wishful thinking and that any economic slowdown would extend to emerging markets. Emerging markets were not immune to the US slowdown. Heavy losses extended over the week to emerging markets and commodity prices (oil included) started a correction founded on lower demand for these products as world growth slowed. In the meantime the two years bond contract was trading around 1.90 in yields with inflation above 2 %. Can you square these numbers?
End of the US session the equity market caught a bid on rumors of an agreement among regulators to help bond insurers. The regulators were working hard to help the monoline / bond insurers getting additional capital (and save their AAA credit ratings). This was the start of a reversal that consolidated next day.

Thursday morning markets woke up with news about a rogue trade of around 5 billion dollars hitting Soc Gen books. Markets looked away and some found here explanations on Monday


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