Blood in the Alleys

The freak-outs continue. Dread that credit blood is flowing in the streets of the global economy received another seeming affirmation today. The European Central Bank (ECB) injected $130 billion of liquidity into the market after short rates spiked overnight. This was taken as a sure and clear signal that global credit markets are indeed imploding right before our eyes…and only the big central banks can possibly save the day.

Yet, Armageddon is nowhere to be found. In fact, quite a bit of evidence rolled in this week indicating credit markets are functioning just fine.

Wave of Issuance Hits High-Grade Market
Dow Jones Newswires, Morningstar

Home Loan Demand Surges as Interest Rates Dive
By Julie Haviv, Reuters
https://www.reuters.com/article/economicNews/idUSN0829171420070808?pageNumber=1

Blackstone Raises Record Fund
By the Editorial Staff, CNNMoney
https://money.cnn.com/2007/08/08/markets/blackstone_fund/index.htm?postversion=2007080810

Look, we're not saying there isn't trouble for a relatively small portion of the credit market—there is. But the notion high yield mortgage credit problems are an economy-busting, seven horsemen-style harbinger of apocalypse just doesn't jibe with reality.

Credit blood is not in the streets of the economy, it's in the back alleys. And that's ok! You'd be hard-pressed to find a time—ever—where there isn't some part of the economy hurting. We often talk about the economy in an aggregated sense—but the fact is the economy is made up of myriad and often disparate sectors and industries. There are always some going up, and others down. Almost never do they all thrive at once. Securitized debt markets, particularly of the high yield variety, have hit a period of turbulence after an incredible run. Again, that's ok.

Today's move by the ECB is really much less scary than it appears. The ECB injected just over $130 billion in emergency funds to European banks after overnight lending rates shot up to 4.7%—well above the ECB's target rate of 4.0%.

That sounds scary until we come to find out the jump in rates came on the heels of an announcement by France's largest bank, BNP Paribas. BNP said it would halt redemptions from three of its investment funds because it can't fairly value the funds' assets. The BNP funds in question are asset-backed short term bond funds invested in US mortgage securities. Combined, these funds hold assets of about $2.8 billion—downright miniscule compared to just about any meaningful credit metric out there. This is small potatoes.

It's impossible to know exactly what caused the liquidity squeeze in European money markets, but it's reasonable to hypothesize BNP's announcement precipitated a spike in risk aversion among already jittery money market investors, leading many to redeem money market funds and hold actual cash. This sudden, unexpected demand for cash possibly caused rates to shoot up as banks scrambled to borrow. In response, the ECB stepped in to provide an additional supply of funds, and rates subsequently fell back toward the ECB's target level.

Again, this is just one possible reason for the ECB move, but it certainly seems plausible. If true, it's a reflection of a temporary shift in investor sentiment, not a fundamental shift in fundamentals.

Perhaps most importantly, we note that it's common practice for central banks to intervene in money markets under these conditions—albeit not at levels of this magnitude. The Fed has been known to inject many billions of new dollars into credit markets on a regular basis to keep their target rate in-line. This is one of the many roles central banks are supposed play in capital markets, and swift action by central banks should ease, not increase investor concerns.

It's perhaps a bit unfortunate that the ECB acted to re-raise investor uncertainty, especially after the Fed's even-handed and appropriate statement on Tuesday. But when the dust settles, it should matter little. Today's market action still has all the credentials of a classic bull market correction, not a new bear market. Financials weren't even the worst performer today! (Industrials and Materials were just as beaten down.)

Actually, one of the day's solitary bright spots was the S&P Distillers and Vintners, returning a stellar 1.8% today. So have a drink and relax. There's no blood to be found in the streets, only the back alleys.

For more thoughts on current market action, central bank moves, and credit markets, see these past commentaries:

• Summer Reading (8/7/07)
• No Credit Messiah Necessary (8/6/07)
• In the Meantime (7/31/07)
• Corrective Measures (8/3/07)
• Debt Disambiguation (7/26/07)