No good news really...

Two weeks away and little seems to have changed. Equities, commodities
and credit are slightly better and bond yields are little changed,
along with FX. The only change of note is short term interest rates as
the money market crisis that I wrote about three weeks ago persists.
Three month libor continues to rise. Yesterday it fixed 99 basis
points over the repo in GBP, almost 75bp over in euro and today
expectations are that 3 month dollars will fix at 5.69%, a level more
synonymous with Fed Funds at 5 1/2 percent.

So far other markets have treated these developments with a remarkable
degree of insouciance. Indeed they seemed to have completely ignored
the deteriorating situation. I can't help believing that this casual
approach is a mistake and largely due to the widespread ignorance of
many financial market participants about the functioning of money
markets, yet ultimately everything comes down to money and it's
availability. And that is the point about what is going on now.

There is a credit crunch going on. Believe it. It just has taken on a
different guise to previous forms. It's not a run on banks but on
non-banks, institutions that have become quasi-banking operations but
lack the capital and depth to ride the storm. The sheer size of the
positions of many of those entities (I can't bring myself to call them
businesses) is staggering. Tiny XYZ bank suddenly has a $20bn dollar
exposure along with numerous "conduit" vehicles and then there are the
SIV lites and the various hedge fund CP based mutants. In short things
are a mess and unless central banks start to properly recognise the
dangers, the situation could reach critical.

This may sound overly dramatic but the risk of a significant failure
is building and LTCM may come to be regarded as a walk in the park.

The problem is of course is that central banks don't seem to recognise
the dangers. Equities et al are not flashing red and the current
situation is unprecedented in recent financial history. Just look at
the chart of 3 month libor versus base rates over the past twenty
years. The spread has occasionally been as wide but this was back in
the late eighties when rates were moving dramatically higher and
interest rates moved in 1 percent steps. The reality is that central
banks don't know how to do to deal with the current situation within
the confines of their existing rule books. [[UK CREDIT CRUNCH.gif]

Fixed rate term repo is an obvious solution, but that doesn't itself
address the problem of financing all the rubbish out there. Ultimately
that will mean a continued liquidity unwind which will inevitably act
on risk asset valuations and economic activity. Rate cuts are
inevitable against this background and the Fed should move by a
minimum of 50 basis points on September 18th and another 50bp on
October 31st. The danger is of that even such aggressive action may
come to be seen as merely pushing on a string.

More later.

Good Luck,

PPG
Patrick Perret-Green
Director
European Derivatives & Bond Trading