Despite wide-spread expectations of a rate cut, the US Fed left key interest rates unchanged (Fed Funds at 2.0 %) at its meeting yesterday evening and stuck to its neutral bias (unanimous decision).

Although the Fed acknowledges that strains in financial markets have increased significantly and labour markets have weakened further, they are still concerned about downside risks to growth and upside risks to inflation (although the wording on inflation has softened).

 

Market reaction: US treasuries weakened, with yields up appr. 20 bps from intraday lows across the curve. The USD profited only briefly, but gave back the gains fast. Maybe the biggest surprise: after briefly weakening in the wake of the rate decision, US stock markets bounced back strongly and ended the day in positive territory (apparently due to increasing rumours about a bail-out of AIG – see below!).

 

Opinion: After the US finance ministry broke with a string of bail-outs some day ago by not supporting Lehman, to mitigate the risk of moral hazard, it seems that the turn is now on the Fed, by breaking with the recent habit of cutting interest rates whenever in a crisis the market is shouting loud enough for a cut.

 

Apart from that, a lower Fed Funds rate would not have helped much, as the problem is not the already very low level of official rates, but the capital scarcity in some parts of the financial sector, which leads to impaired access to market liquidity.

 

Nevertheless the Fed took the risk of disappointing markets, as the rate market had already bet on a 25 bp rate cut (and another one until Q1), with only expectations of a 25 bp cut by spring 09 now left in the curve.

 

But as the Fed already knew about the impending rescue of AIG (the credit line is coming from the NY Fed), they did not risk too much in terms of market sentiment.

 

Rescue of AIG: As announced late at night yesterday, the US government has come to the rescue of US insurance giant AIG with a USD 85 bn credit line, in exchange for majority ownership rights in the company. An insolvency of AIG is therefore no longer a danger.

 

Outlook: Although the chance for a rate cut is still alive in the coming months, we still consider unchanged rates over the coming quarters as the most likely outcome.

 

In terms of supporting the financial system, further structural measures (increased and easier access to central bank money, additional refinancing lines against an even broader collateral base, in a worst case concerted efforts by global central banks) are more likely (and helpful) than mere rate cuts. Different from Euroland, the official interest rate level is already appropriately low in the US.

 

Bond market: As there will probably be some more improvement in market sentiment for risky assets after the rescue of AIG, bond markets could easily correct a little bit more in the very short run. The medium-term outlook for government bonds remains bright, though, given the falling trend in economic growth and inflation. Further price corrections on the bond market would therefore lead to a new buy recommendation from our side soon. 

 

Equity markets: Although the decision of the US Federal Reserve to keep key interest rates unchanged temporarily disappointed investors, US stock markets clearly ended the day in positive territory. Especially rumours (which came true after the regular session) that US authorities may finance a rescue of heavily rattled insurer AIG were the main reason for the rebound. Fears of a systemic crisis in the financials system should therefore be dampened for the time being and should support stock markets at least to some degree. Nevertheless we do no expect a sustainable recovery in the months to come. On the one hand the liquidity situation on markets and at a couple of financials is still tight and a renewed worsening can therefore not be ruled out. On the other hand the collapse of Lehman Brothers will of course leave its marks (write offs) on the balance sheets of many financial companies. Additionally the news-flow from the economic front should remain negative in the coming months and keep being a burden for international stock markets.