Overview: Central banks battle to bolster confidence

The mood of uncertainty engulfing financial markets intensified on Tuesday as anxious investors awaited news on whether ailing insurer AIG would become the next victim of the financial crisis.

Optimism that a bailout deal might be hammered out helped stem a sell-off in the equity and credit markets, although the underlying sense of fear among investors was highlighted by a desperate scramble for short-term cash.

Money markets went into virtual paralysis as interbank lending rates soared, reflecting mounting fears about counterparty risk.

“Cash is becoming king as Lehman’s bankruptcy works its way through capital markets,” said Daniel Pfaendler, head of G10 economics & strategy at Dresdner Kleinwort.

“The ‘great unwind’ - the unwinding of asset bubbles, over-leverage in the financial sector and private households as well as economic imbalances in general - is taking its toll.

“The immediate effect is risk aversion and deleveraging, raising volatility and hitting currencies, credit and equity valuations, and ultimately growth.”

The overnight dollar Libor rate ballooned to 6.44 per cent, more than three times the Federal Reserve’s target Funds rate and the highest since January 2001. Overnight sterling rose to 6.79 per cent against the Bank of England’s 5 per cent base rate.

The gap between three-month dollar Libor and the overnight index swap rate - a key gauge of banks’ willingness to lend to each other - widened to 116 basis points, the most since the credit crisis erupted last August.

The heightened stress came even as central banks pumped tens of billions of dollars of emergency funds into the markets for a second day.

“Intervention seems almost certain to continue as market nerves are in tatters and term interbank liquidity is virtually non-existent,” said Icap Europe.

Investors were waiting to see whether the Fed would cut interest rates on Tuesday in a bid to offer further relief to the markets.

Concerns about corporate defaults pushed credit spreads sharply wider, although talk of an AIG lifeline pulled them back from near-record levels.

Hopes over AIG helped US and European equity markets pull off the day’s lowest levels.

By midday in New York, the S&P 500 was down 0.2 per cent, having been 2 per cent lower at one stage. On Monday, the benchmark closed at its lowest level for nearly three years. AIG’s shares were down more than 40 per cent at one stage during Tuesday’s session.

In Europe, the FTSE Eurofirst 300 index fell 2.6 per cent to its worst close since May 2005. Tokyo was met by a wall of sellers as it reopened after Monday’s holiday and the Nikkei 225 fell 5 per cent to a three-year low.

Emerging market equities saw further heavy selling as risk aversion intensified. The MSCI EM index dropped to its lowest level since 2006 as Russia’s RTS index tumbled 11.5 per cent, the worst one-day drop in a decade. Trading was suspended for the last hour of the session.

The spread of emerging market sovereign debt over Treasuries widened to the most since October 2004. EM currencies were also weak, with the South Korean won suffering its biggest one-day decline for 10 years.

US government bonds gave back early gains as speculation of an AIG rescue gathered pace. The yield on the 10-year Treasury touched a five-year low of 3.25 per cent before rebounding to 3.42 per cent at midday, up 1 basis point on the day.

European bonds held in positive territory, with the two-year Schatz yield down 5bp at 3.67 per cent, but well off an earlier low of 3.59 per cent.

On the currency markets, the dollar continued to advance as risk aversion heightened the attractiveness of the US currency and commodity prices continued fall. The yen and Swiss franc also continued to benefit from their perceived safe-haven status.

In commodities, US oil extended its recent fall below $100 a barrel, and base metals weakened. Gold saw some safe-haven buying but failed to retest the $800 an ounce mark.

Against the backdrop of the market turmoil of the past few days, encouraging US inflation data and a bounce in the German ZEW sentiment indicator had virtually no impact.


The Financial Times Limited 2008