How Should We React to the Liquidity Crisis?

The European Central Bank and the United States Federal Reserve are bailing out the financial markets right now.   BNP Paribas declared that they are suspending withdrawals from three of their investment funds, and the market reacted pretty poorly.  The overnight lending rate for euros shot up to 4.7%, leading the ECB to distribute over 155 billion euros over the past two days.  The Fed, which has seen two straight days with the LIBOR rate above the benchmark rate of 5.25%, has added $43 billion in temporary cash.  The Bank of Japan and the Reserve Bank of Australia, this morning, added $8.5 billion and $4.2 billion, respectively.

Risk aversion has been on a steady climb recently, and naturally, the demand for liquidity has skyrocketed.  Central banks around the world have used their tools to ameliorate the crisis.  The real problem is what message this sends to participants in the financial markets, whether it be equities or foreign exchange.  The last time there was a bailout this large was right after September 11, 2001.  Earlier this week, both the ECB and the Fed were talking about how credit conditions were manageable.  The Reserve Bank of Australia raised its interest rate to 6.5%.  The Bank of England basically came out and said that they were ready to keep raising interest rates for the near future.  What do the central banks know now that has caused them to change their positions?  And what do the commercial banks in Europe and America know that led them to accept the loans?  Is the US subprime crisis a worldwide issue now? Bear Sterns Chief Financial Officer Samuel Molinaro came out and called this the worst fixed income market that he has ever seen.  And the primary driver for investors is fear, fear of what the answers to those three questions are.

It would be a different scenario if it was only firms on Wall Street losing money.  It would hurt the US economy, but the influence would be limited.  But what a liquidity crisis means is higher interest rates.  For everyone.  Analysts across the spectrum have been chirping about how the era of easy money is over.  There are billions of dollars worth of adjustable rate mortgages that still need to be re-priced according to current interest rates in the coming months.  The housing situation is on track to get worse, with foreclosures even higher than before.  About seven million Americans are slated to lose their homes.  And with homes so important to personal equity and wealth, the problems will stifle individual growth and consumer spending.

In the short-term, the US dollar actually benefits from market uncertainty.  Risk aversion and volatility (Chicago Board of Option VIX survey is at a 4-year high) lead traders to park their assets in US dollars.  Counterintuitively, the US subprime crisis puts support under the US dollar.  But it’s time for the Fed to ease credit.  What has been done so far is not enough, and interest rates have to be lowered; money has to be thrown in to the financial markets.  The lower interest rates will counteract the safe haven status of the US dollar for now, but it is what is needed for the US economy to get through this situation.  Lower interest rates and greater liquidity will hurt dollar bulls in the short-term, but they will benefit the US economy (and therefore the US dollar) in the long-term.