The US House of Representatives yesterday turned down the USD 700bn financial rescue pacakge after 10 days of discussion and despite the compromise that had been worked out over the last days. At the same time, the forced sale of Wachovia increases insecurity of banks and market participants. Citigroup is taking over Wachovia's banking operations. Wachovia was the fourth largest US bank. In Europe, Fortis and HRE were in need of government support.
The US Senate will probably try to revive the bank-rescue bill as early as today, trying to find a compromise that will pass through. However, confidence of market participants has dropped further, and in combination with concerns regarding the scope of the proposed rescue plan, the effectiveness of the plan is highly disputed.
Should the confidence of market participants decline further and should the US fail to undertake effective measures to restore it, we believe there will be severe spillover effects on the real economy in the US. The greatest danger emanating from the financial crisis is that banks will severely cut down lending to the corporate and the private sector, which will directly translate to US GDP growth. So far, consumer lending is holding up, while commercial and industrial loans are giving in. In our opinion, there will be a severe US recession if no credible solution is found and confidence in the global financial system is not restored. A major bailout plan is inevitable as deleveraging cycles necessitate major government action.
A high degree of risk aversion continues to be seen on financial markets:
Inter-Banking Market:
Liquidity on the inter-banking market continues to be tight. The difference between Treasury and Libor rates, which measures the costs of financing that banks are facing, remains close to a record high in the US. In response to continued strains in short-term funding markets, central banks have announced further coordinated actions to expand the capacity to provide US dollar liquidity. Together, the major central banks have provided a total of USD 620bn of liquidity in order to reassure financial market participants that financing will be available against good collateral.
Bond Market:
Investors continue to turn to the bond market in their flight to safety, and especially in the US, yields have consequently dropped significantly. Between Friday and Monday, 10-year US Treasury yields fell from 3.85% to 3.58%, 2-year yields fell from 2.1% to 1.66% and 3-month Treasury yields more than halfed, falling from 0.84% to 0.35%.
Equities:
As a result of the failure of the rescue plan in the US, the emergency sale of Wachovia and the government help for Fortis and HRE, equities slumped on a global basis in the worst global sell-off in 21 years. The S&P 500 fell 8.8% yesterday and is down almost 25% ytd, the Nasdaq fell 9.1%, and implied equity volatility (VIX) in the US jumped to a record reading of 46.7%, above the measures seen in the 2001/2002 bear market.
