Pushing On A String

(originally published on February 16, 2008)

Technorati Tags: crisis of confidence,pushing on a string,investment grade spreads

 

Lets recall that statement from Bernanke again...  “more-expensive or less-available credit seems likely to continue to be a source of restraint on economic growth”. We know where this is coming from, with the Fed having cut the Fed funds rate by 225 basis points in six months. But deteriorating credit conditions have undone pretty much most of what the Fed has done. The yield on Baa corporate bonds – a better measure of what drives actual business spending than the Fed funds target rate – has stayed largely constant, widening its spread over the Fed funds rate.

 

Spreads widening even for AAA rated corporate bonds as investors shun risk entirely

 

Merrill Lynch data indicating a sharp widening of spreads for investment grade issues

Data compiled by Merrill Lynch suggests that companies are paying more to borrow now than before the aggressive Fed rate cuts in January. Rates on so-called jumbo mortgages – mortgages with a value of over $417,000 and those not guaranteed by Fannie Mae and Freddie Mac – have increased in the past month, according to Bloomberg. Lenders and investors alike are demanding greater compensation for offering credit as losses continue to mount on sub-prime mortgage securities amid concerns of a cut in credit ratings of bond insurers. The increase in credit spreads has contrarily resulted in an effective tightening of financial conditions that the rate cuts were partly meant to address. It is as if the Fed were pushing on a string. The market perceives elevated borrowing costs will force the Fed to make further rate cuts, thereby reinforcing the 'negative feedback loop' that has been in vogue all through this crisis. Traders now place a 100% chance of at least a 50 bps rate cut on or before the FOMC meeting on March 18.

A crisis that began with loans made to a small group of home-buyers with shaky credit has disrupted pretty much the entire financial ecosphere. Indeed, small towns in far-flung Norway have lost money due to the sub-prime contagion in the US. It has proved to be much more than a credit crunch... it has become a crisis of confidence.