For The Fed: Try, Try Again

It's certainly not for lack of effort. The global financial market crisis has decimated stock exchanges across the world this week, in spite of several efforts by the US Federal Reserve to reassure investors. In the latest rescue measure, the Fed announced early Thursday that the world's main central banks would inject $180b of dollar liquidity into the market. Along with the European Central Bank, the Bank of England, the Bank of Japan, the Bank of Canada and the Swiss National Bank, the Fed's Board of Governors approved a plan for emergency intervention.

Officials hope the new liquidity will help thaw a frozen credit market. On Wednesday, interbank lending ground to a halt, as the capital flight to "safety" saw a huge increase in the demand for US treasuries. With banks hoarding their cash, overnight lending rates were at record levels this week, as measured by the London interbank offered rate (Libor). While the US central bank has a target of about 2% for short term interest rates, these lending rates shot up on the open market. The Libor was at 5.03% on Wednesday, although the rate was already easing (down 119 basis points) with the announcement of increased liquidity. 

Two other variables highlighted the severity of the crisis. The government repurchase (repo) market stalled on Wednesday with the overwhelming demand for securities. In repo agreements, the Federal Open Market Committee effectively buys treasuries from primary dealers in order to increase reserves in the banking system. The transaction works as a loan with the treasury security as collateral. This week, however, skittish investors have grabbed up bonds and exhausted supply. 

The swap spread also yawned this week, with the so-called TED spread clearing 3% for the first time since the stock market fall of October 1987. The swap spread is a barometer for risk appetite in the economy, with a wide spread signaling a lack of confidence in the market. It is a measure of the difference between fixed interest rates (usually the Libor) and US treasury rates, which moved sharply in opposite directions this week. 

The liquidity injection appeared to rally the markets, though the effect seems transient. Asian stocks experienced volatile trading and ultimately closed at their lowest levels since last October. European markets posted modest gains, but the Dow Jones Industrials Average was trading below the day's open.

Banks from the world's largest economies rallied together after the staggering consequences of Lehman Brothers' collapse on Monday. There is a pressing need for dollars as many banks have their reserves tied up in Lehman's bankruptcy proceedings. In general, money markets have been under considerable strain this week as investors move out of stocks and into cash. This trend may well continue until the Darwinian climate reaches a new equilibrium, and investors come out of hiding. 

The central banks' liquidity deal was announced at 3am in the US. If this past week is any indication, financial officials still have many sleepless nights ahead.