Why these central bank rate cuts are not working
Three-month Libor settled at 4.75% today, and as the spread between three-month treasuries and three-month Libor (TED spread) breached the 400bp barrier. Are these indicators of liquidity simply awaiting adjustment following the completion of the Lehman Brothers credit default swap auction on Friday? Or, is the TED spread a true reflection of the quality of residual risk in the international and bank sector?
Rather than wasting their time wondering why the across-the-board cut in interest rates by central banks is failing to instil confidence amongst capital market participants, central bankers should be seeking answers in the status of the 60 trillion credit default swap market and, for that matter, in a few more tens of trillions of dollars worth of contracts governing interest rate swaps, basis swaps and currency swaps, and related options. In fact, the sheer immediacy of the problems inside the entire derivatives complex should be of much greater concern than trying to force downward revisions in benchmark rates for treasures and bills.
Of course, recent Libor levels may well be incorporating an overdue dynamic: the degradation, over the next few months, of financial and corporate balance sheets consequent to revaluations demanded by the dramatically changed global economic environment.
The common argument going around today is that the liquidity transfer mechanisms allowing for a central bank rate cut to have the desired impact on the broader marketplace are currently in suspension and that, with time, lower benchmark rates will bring a semblance of normality to day-to-day business. That argument, however, is fundamentally flawed. The transfer mechanisms which worked so well in the previous decades are not suspended; they have, for all material purposes, been comprehensively destroyed. And one does not have to go far to find the reasons.
Firstly, the maturity mismatches (long term assets compared with short term liabilities) are rampant right across the banking and corporate spectrum, and impaired capacity of assets to service debt obligations in the existing climate is acting as a formidable constraint to any activity designed to utilize central bank windows. Secondly, doubts relating to compliance with debt service obligations are casting dark shadows over valuations in all asset classes; therefore, the reluctance to lend and the willingness to hoard free cash.
Finally, despite wave after wave of regulation since the 1970s, most banking and corporate disclosures do not meet the standards required to make credible assessments of risk in the first place; the fear of the uncertain, as a consequence, is now being augmented by the dread of the unknown.
Even if only for tactical purposes, rate cuts are counterproductive today, since they only serve to accelerate the implied (adverse) readings obtained from key market indexes (the TED spread, the Overnight Index and basis swaps).
Rate cuts do not take into account the more-than-obvious fact that there has been a seismic shift in the very structure of the capital markets over the last two decades, a shift primarily characterized by the exponentially rising influence of risk-pricing in derivates contracts on traditional cash transactions.
The sad part of this mess is that central bankers today are assumed to possess sufficient resources (and, hopefully, expertise) to determine the impact of a rate cut well before making decisions on rates and liquidity, from data publicly available in the futures, options and benchmark-fixing markets. Why then are corporations and individuals being led to believe that these bailouts and rate cuts are going to bring near-term or long-term relief? Why is this rather complex credit crunch being explained away by reliance on the dubious virtues of brevity and simplicity?
Most importantly, why have the guardians of the bailouts (or rescues) in
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