Chaos Continues in the Money Markets

The Fed’s move on Friday to lower discount rates and its policy shift towards addressing risks to growth has not brought relief to the sector that was in the most distress, the money markets.

Panicked action continued Monday, begging the question of what, if anything, the authorities can do. Institutional are fleeing from counterparty risk of any kind, and money market funds are steering clear of commercial paper and fleeing to Treasuries, which staged a bigger rally than in the 1987 crash.

This begs the question of whether any Fed further Fed action would constitute pushing on a string. After the 1929 crash, the Fed (contrary to popular opinion) did the right thing and pumped funds into the banking system. The monetary base (currency in circulation plus bank reserves) went up. But money supply contracted sharply because bank failures led the public to remove funds from the banking system, effectively taking it out of circulation and rendering the Fed’s action ineffectual

It seems that the markets need confidence more than cheap funding, but they may have to find it on their own, since none of the people in charge is skilled in the art of reassurance.

And in classic fashion, as we will show later, the Journal does its best to downplay the severity of the situation, although in this case the facts are so grim that there is only so much burnishing even they can do.

First, from John Authers of the Financial Times:

Money market investors staged a dramatic flight to safety on Monday, knocking down yields on short-term US government debt, as top Treasury and Federal Reserve officials continued behind-the-scenes efforts to maintain confidence in the credit markets.

The yield on the three-month Treasury bill fell 66 basis points to 3.09 per cent after being down by 125 basis points during the day – a greater plunge than during the October 1987 stock market crash. The yield on the one-month Treasury bill fell 62 basis points to 2.33 per cent after being down 175 points….

The frantic scramble to obtain short-term government paper at almost any price suggests the Fed’s move on Friday to make credit available to banks on more attractive terms has yet to stabilise the markets.

This in turn encouraged speculation the central bank would have to cut the federal funds rate, its main interest rate. In a sign of growing political attention to the crisis, Ben Bernanke, Fed chairman, and Hank Paulson, Treasury secretary, were to meet on Tuesday with Senator Christopher Dodd, the Senate banking committee chairman.

Analysts said the plunge in T-bill yields was driven by money market funds, which hold $2,700bn in assets, shifting away from asset-backed commercial paper, which promises investors the cash flows from mortgages and other loans.

In response to investors’ pressure, funds that previously had sought to boost returns with more aggressive strategies have been selling asset-backed commercial paper and raising their holdings of government securities. At the same time, money is piling into traditional funds that only buy government debt.

“We had clients asking to be pulled out of money market funds and wanting to get into Treasuries,” said Henley Smith, fixed-income manager at Castleton Partners. “People are buying T-bills because you know exactly what’s in it.”

Data from Dealogic showed companies in Europe failed to refinance more than 80 per cent of asset-backed commercial paper that matured on Monday….

Mr Paulson and senior Fed officials were talking to large institutional investors and banks in an effort to calm markets, but policymakers denied they were trying to talk up prices.

By contrast, consider this story from the Wall Street Journal:

Investors largely shrugged off the Federal Reserve’s attempt to restore order to the credit markets and bought up the safest government securities, triggering the biggest drop in yields on short-term Treasury bills in nearly 19 years.

While the stock market rose, conditions improved in currency markets and several companies successfully sold new bonds, investors refused to take any risk with their cash holdings. Instead, they accepted sharply lower yields in exchange for the safety of government bonds. Their actions signaled that the Fed, which moved Friday to shore up confidence in the markets, has failed so far to persuade investors that problems in securities linked to subprime mortgage loans wouldn’t cause widespread losses in normally safe securities….

This is a bloodless and verging on misleading presentation. A panicked flight from risk is recast as a casual “shrugged off.” While the facts are largely intact, the color has been airbrushed out. As the story progresses, the collective anxiety nevertheless bleeds through:

Mutual-fund companies such as Vanguard Group and Fidelity Investments say they have been flooded with calls from investors asking whether their money-market funds hold commercial paper backed by mortgage securities. Vanguard said its money funds aren’t exposed to subprime-mortgage assets, and Fidelity said it has “minimal” holdings of them. Still, in many cases investors have moved their money to lower-yielding Treasury funds….

Money-market managers themselves are worried about losing money or “breaking the buck,” a reference to the stable net asset value of these funds. Michael Cheah, a fixed-income portfolio manager at AIG SunAmerica Asset Management in Jersey City, N.J., said a colleague recently asked whether he should invest in a seven-day commercial-paper issue from a large U.S. bank. The paper bore an attractive yield of around 5.5%.

“I told him: ‘This is all about safety. If we break the buck, we will lose our bonus and may get fired,'” said Mr. Cheah, adding it would be better to invest in Treasurys. The manager decided to put the money in a short-term Treasury repurchase loan that paid 4.3%….

“The market is clearly saying that what the Fed has done isn’t enough. We’re having a crisis of confidence, and investors with the cash have no risk appetite at all,” said James Kauffmann, head of fixed income at ING Investment Management in Atlanta…..

Fed officials have indicated they expect it to take some time before they know whether their actions have restored confidence to the debt markets. Some economists say the Fed may have only a few days to wait for market conditions to improve. If conditions deteriorate, it will have to take the more aggressive step of cutting its main interest rate target, the federal-funds rate, from the current 5.25%.

Stephen Stanley, chief economist at RBS Greenwich Capital, said the Fed has given the impression it would prefer not to cut rates at all, and that if it had to, it would do so at its scheduled Sept. 18 policy meeting. “But given what happened today, I’m not sure they’ll make it that far.”….

The European commercial-paper market also struggled despite recent injections of capital. Yesterday, traders in London said trading was difficult; investors demanded higher yields and shorter durations. In a research note yesterday, Deutsche Bank analyst Ganesh Rajendra said, “Never before in our memory has the European structured finance market looked so fragile.”

But the Journal managed to find a positive thread;

Still, many analysts say it is too early to measure the full effect of the Fed’s effort to improve liquidity by encouraging banks to borrow. Stocks rose yesterday as investors digested the Fed’s move. The Dow Jones Industrial Average gained 42.47 points to 13121.35, on top of Friday’s 230-point advance.

One positive sign from the credit markets is that several companies managed to sell new bonds yesterday. SABIC Innovative Plastics sold $1.5 billion in junk bonds to fund its buyout of General Electric Co.’s GE Plastics unit, agreeing to pay 9.5% interest on the debt. It was the largest junk-debt sale since a sale of loans by Chrysler Group in late July. Comcast Corp., Bank of America Corp. and Citigroup Inc. also issued new investment-grade bonds….

In other currency markets, volatility declined in comparison to last week. The relative calm “doesn’t necessarily mean that nervousness is declining,” said Jens Nordvig, a currency strategist at Goldman Sachs. “There’s not much appetite to trade.” The elevated uncertainty about where money-market rates are heading is also making it more difficult to price currency forwards, which are contracts used to trade a currency at some future date. If there’s going to be abnormal volatility in prices, “You need a strong desire in order to trade at all,” said Mr. Nordvig

In other words, there is some hope that the problem will remain localized and therefore diminish. No one dares use the discredited word “contained.”

The most encouraging news comes from Asia. The Nikkei is up strongly as of this hour and the yen is falling, which seems to mean that Mrs. Wantanabe is coming to the rescue through the carry trade. Let’s hope investors here take notice.