US Federal Reserve Cuts Interest Rates, Credit Market Still a Disaster

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What if the Federal Reserve cut the discount rate and nobody borrows money? You can make money cheaper, but you can’t make a banker borrow. We’ll find out this week if Ben Bernanke’s Fed has helped the market dodge a bullet. We doubt it.

In case you missed it, the US Federal reserve cut its discount lending rate by 50 basis points Friday morning in New York. The discount rate is what commercial banks pay to borrow directly from the Federal Reserve. Commercial banks are not borrowing a lot from the Fed these days, being scared stiff of the imploding market in asset-backed securities, but that didn’t seem to bother the market. The news was well received.

The Dow rose 233 points to close above 13,000 and the S&P 500 had its best day in four years, closing up 2.46%. But the biggest winner from the Fed’s Friday move is not going to be the Dow, the S&P, or the ASX/200. It’s going to be volatility.

For all the smoke and mirrors, the Fed didn’t really do anything except soothe some frayed nerves on Friday. That was enough for a rally. But the Fed’s discount rate is not the same as the Federal Funds rate. The Federal Funds rate is the rate banks charge one another to loan money overnight. That rate still stands at 5.25%. And unless something has changed over the weekend, banks are still petrified of taking any risk.

In other words, the credit markets are still a disaster, littered with assets no one can value in a thinly traded market. Myles Zyblock at RBC Capital Management writes that “the complex derivatives instruments born from the credit boom are doing little to structurally assuage risk. More to the point: These very instruments encouraged profligate risk exposure and are now inflating the sense of anxiety because their opaque nature has made it difficult, if not impossible, to pinpoint ultimate risk exposure.”

The Fed has done a favour for highly-leveraged investors, though. The futures market is now all but certain the Fed will cut the funds rate, maybe as soon as this week. The currency markets responded by trimming the US dollar’s recent gains. This allows all those investors who borrowed dollars to invest in higher-yielding assets a chance to sell stocks in a rising market, raise some more cash, and pay back those loans.

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. you are writing some good stuff Dan. As much as earnings are strong and fundamentals are good, I just can’t see much up-side.
    In an industry where we’ve got our fingers on the pulse of a few (tens of) billions of dollars- struth, BankWest @ 7% doesn’t look too bad you know.

    dubious pete in melbourne
    August 21, 2007
    Reply

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