Zaks Investment Advisory Service

Financial markets during the past week

Today we will continue our review of the markets, thanks to their somewhat unusual behavior. Last week was just as erratic and volatile as the one before it. Thursday and Friday are good examples: at one point Thursday, the Dow Jones fell by 340 points, then gained 300 points in a matter of an hour at the end of the day. On Friday, the index soared another 300 plus points in the first 30 minutes of trading. What has gotten into our market? As you have probably heard, on Friday the Federal Reserve lowered the rate it charges at the so-called discount window. What is it? Why, in response to unexpected and unusual intervention from the central bank, did the market go up? After all, a week ago, when the European Central Bank intervened in its market, that fell by four percent.

The US market continues to run a fever and its cause remains the same: risk and fear of the unknown. We still do not know what other troubles lay in store for the financial markets, not until they finally manage to sort out the risky bonds issued on the basis of subprime loans. This uncertainty is suspended over the market like the sword of Damocles. Which financial companies hold these bonds? Are these companies and funds sufficiently liquid, i.e. do they have enough assets that could be sold quickly to settle financial debts? This is a very important question, for if their liquidity is in doubt, they would have problems getting even short-term loans and many firms would stop trading with them. And most importantly, what will happen to the subprime mortgage bonds themselves? Some of their collateral comes in the form of mortgages with variable payments that depend on interest rates. What happens if interest rates go up? Will the mortgage holders still manage their payments? Or, in a different pessimistic scenario, if our economy stalls and unemployment grows, how will this affect subprime mortgages? All of these potential problems mean that the US market, and nearly all world markets in its wake, simply cannot calm down: on Friday, for example, Japan’s Nikkei 225 fell by nearly 5.5 percent even while many of the European markets got stronger. In order to better explain these market events, Russia’s financial press even made up a new term, the transliteration of our English word “volatility.”

As I have said, on Friday the Federal Reserve lowered its so-called discount window rate. What is it? As we know, the Federal Reserve usually works with the credit market through so-call open market operations. When the Federal Reserve wants to infuse money into the banking system, fearing that economic activity is stalling or to add liquidity on a temporary basis, it purchases securities on the open market. When it wants to reduce the amount of money in the system, having assumed, for example, that the economy is overheating, it sells securities from its reserve. By the way, we described the mechanism for how this works in one of our previous programs: http://zaksadviser.com/radio/NZ20_MoneyFed_part2.html. But open market operations are not the only instrument in the Federal Reserve’s arsenal. Our central bank also regulates the amount of money in the banking system through the discount window, although this happens less often. The discount window is simply an opportunity offered by the Federal Reserve for banks to borrow money directly from the Federal Reserve, rather than each other. As we know, banks usually prefer to take out temporary loans from other banks. Banks only turn to the Federal Reserve when they have no other hope for borrowing money. When a bank is in a bad state and other banks refuse it credit, it may turn to the Federal Reserve and get short-term capital, usually at a fairly high rate. In banking circles, this bears a stigma, which is why banks try to avoid the discount window. On Friday, the Federal Reserve did three things: first, it lowered the discount window rate; second, it allowed banks to borrow money over a longer term; and third, it urged the banks to use this opportunity, declaring that under the circumstance there was nothing wrong about it. All of the American markets, from the money markets to the stock markets, reacted positively to this step: the S&P 500, for example, gained 2.5 percent, the most in the last four years.

Why did the Federal Reserve decide on such a move? Our central bank usually does not react to market price fluctuations. Its mandate is quite limited: supporting low inflation and unemployment levels, and guaranteeing uninterrupted bank operations. Supporting the Dow Jones at a high level, or averting the bankruptcy of some hedge fund or mortgage company such as Countrywide Financial, is not a part of its job description. Over the past few weeks, the Federal Reserve was fairly firm and only intervened with market activity in the most limited sense. Even now, for example, it has refused to lower the Federal Fund Rate, its main lever of influence over the economy. Nevertheless, the Federal Reserve judged that credit market troubles resulting from a revaluation of risk on some securities might keep both banks and non-financial companies from accessing short-term loans. These loans, which are called “commercial paper,” are vitally important to many companies. With their help, for example, they take out loans in periods between their long-term bond issues. Potential difficulties on the financial markets could have thus affected economic activity. Which is why the Federal Reserve decided to tinker with the well-tuned – and, at the moment, nicely running – financial machine. Its step was mostly symbolic, largely aimed at demonstrating that the Federal Reserve was carefully watching the events unfold, ready to step in when necessary. And this is something the financial markets always cheer.

And with this, we will close our program for the day. This was Sergey Zaks. Thank you for your attention and until next time.