Plans for substantial support package!

In the light of the dramatic culmination of the confidence crisis in the financial system in recent days, the US government has come forward with a proposal for a substantial support package, which is currently being discussed with congress.

The plan is to set up a government-funded institution which would buy distressed (mortgage) assets from the books of financials, similar to the Resolution Trust Corp. (RTC), which was the ultimate strategy to stabilize the financial system after the Savings- and-Loan Crisis (set up in 1989).

Although so far no steps have been agreed upon in Congress yet, and therefore neither details nor volume can be determined, this would be an important step to put a floor under distressed mortgage assets and stabilize confidence in the financial system. 

Of course such a measure would not lead to fast economic recovery (our economic forecasts remain unchanged), nor would it prevent the failure of further weak institutions. But it would be a big step from mere liquidity support by central banks and single-point rescues of individual companies towards tackling the underlying asset-market problem. As in the end such a measure is probably inevitable to stabilise the US financial system, it would be very positive if it could be agreed upon already soon and with substantial funding. This would bring the end of the financial crisis a big step closer, sharply reduce the panic about systemic banking problems and therefore also reduce risk premia for financials, e.g. for their funding. 

Market reaction: Stock markets rose sharply, with a parallel correction on bond markets.

Outlook: The mere announcement of the plan has propelled stock markets higher, and after the panic of recent days there is probably enough fuel to drive the recovery rally even higher in the short term.

For the bond market this would mean a further correction of prices in the short-term – we therefore strongly advise against open long positions for bonds in the short run. Although the medium-term outlook for bond prices remains favourable, in the short-term the turn-around in risk-aversion will definitely dominate.