31 July 2008

Infinite fiat draws near

The Fed said it was extending its support to primary dealers “in light of continued fragile circumstances in financial markets”.

The options facility is similar to the strategy used by the Fed in 1999 to deal with the risk of a millennium Y2K liquidity crisis. The Fed will auction $50bn of options giving dealers the right but not the obligation to swap illiquid securities for Treasuries over periods of likely funding stress, such as the year-end.

The European Central Bank and the Swiss National Bank will also offer three-month dollar loans through the offshore dollar facility set up in conjunction with the Fed. The Fed will increase the amount of dollars it provides to the ECB in exchange for euros by $5bn to $50bn.

Goldman Sachs said the moves “should help to . . . alleviate market stresses, but are incremental rather than transformational”.

Its latest initiatives follow the recent turmoil in financial sector stocks, which creates a risk that the credit squeeze in the real economy could intensify in the coming months.

The US central bank does not believe it can solve what are in many cases capital problems by providing extra liquidity. But it does believe that it can support the adjustment process by reducing the risk of a liquidity run on any individual institution or any forced firesales of illiquid assets.

The Fed's acknowledgement of the continuing stress in financial markets makes it improbable that it will raise interest rates soon. However, in the longer term, Fed policymakers believe that liquidity tools and rates could in principle diverge.

The decision to offer $75bn in three-month loans (replacing $75bn of one-month loans) marks an important concession by the Fed, which had resisted pressure from banks to extend the term from the previous single month.

The creation of a new options facility, meanwhile, is intended to pre-empt stress “in advance of periods that are typically characterised by elevated stress in financial markets, such as quarter ends” and the year-end.

The S&P 500 index rose 0.7 per cent to 1271.62. The Dow Jones Industrial Average was up 0.8 per cent at 11,489.81. The S&P financials index was down 0.2 per cent and the homebuilders sector was also in negative territory at lunchtime in New York.

The yield on the two-year Treasury rose 2 basis points to 2.637 and the 10 year yield was also up 2bp at 4.060.

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