Discount Rate Cut Just Window Dressing

Yesterday, we stated that there would be little empirical effect of the discount rate cut on the international credit crunch.  Until the Fed actually cuts the Fed Funds rate (and that will not happen until September at the earliest), markets around the world are going to continue to be wary.  The equities markets are sending mixed signals about the health of the financial economy.  But the real signal is the credit markets because that is the epicenter of the crisis.  And it is there that we see the negligible effect of the Fed’s decision: yields on one-month and three-month bills are skyrocketing.

Asian stocks, led by the Nikkei, rebounded from their horrendous fall last week.  But European traders have been more cautious, and the net result on the Continent is a downward trend on equities.  The German ZEW survey of analyst sentiment did not help, printing at -6.0 vs. -1.0 expected.  Investors have been more accepting of risk than in recent days, as signs of a carry trade rebound have shown up in the market.  As evidence of that phenomenon, the yen crosses have begun to edge higher.

But looking at the credit market, there is still reason to remain bearish on international prospects.  Commercial paper is being avoided like the plague, not only in the United States but in Europe and Asia as well.  As an alternative, investors are rushing to US Treasuries, as they are really the only completely safe investment left.  Yields are being driven to multi-year highs.  Even the Bank of England, which stood on the sideline all of last week, is beginning to get involved in easing the credit crunch.

Forex sentiment on the US dollar is mixed.  The run of Treasuries should provide a strong support for bids at the moment.  But the housing recession and credit problems started here, and their final effects are likely to manifest themselves most strongly here.  Although that probably means bad news for the entire world, as when the US sneezes, the rest of the world still gets a cold.  Foreign exchange traders should remain bearish on the USD/CAD and bullish on EUR/USD and GBP/USD, especially considering the coming Fed Funds rate cut.

But there might be a problem with that scenario as well.  Recent reports show inflation in developing countries to be as strong as ever.  In China, the only real solution to that is to let their currency appreciate, something the government is still loath to do.  In India and Brazil, global demand has prices skyrocketing.  Developed economies may be experiencing a credit crunch, but emerging markets around the world may actually be confronted with excess liquidity.  A loosening of credit conditions in the United States could lead to an exporting of inflation internationally, and the primary job of a central bank (no matter what Bernanke or any politician might say) is still price stability.  Which means we might not see that rate cut in September after all.  And then we should prepare for all hell to break loose in the financial markets.