Helicopter Ben Faces His First Financial Crisis: What Will He Do?

It appears that no Federal Reserve Chairman is able to escape the first year curse. Although we are a few months beyond the first year mark of Ben Bernanke?s term, the current credit crunch has been slowly gnawing at the economy since the beginning of the year. In the past three weeks, we have seen a drastic shift in investor appetite. The Dow has plunged 1000 points at its low point this morning, two year Treasury yields hit an 18 month low, while carry trades as a basket have fallen over 6 percent, which is the fourth largest drawdown since the inception of the Euro.

As risk aversion rises, speculators and investors have been liquidating out of their risky positions and moving back to cash. The lack of buyers across the markets has forced hedge funds to freeze redemptions and mortgage lenders to report major losses. For the credit market, this drove short term interest rates to six year highs, forcing central banks around the world to respond with massive liquidity injections.
[B]What is the First Year Curse?[/B]
Since 1970, every Fed Chairman that assumed the top job has faced a major crisis shortly after entering office. According to Toni Straka of Prudent Investor, “Arthur F. Burns, chairman from February 1, 1970, climbed the top chair only to oversee the beginning of the 1970’s bear market, the closing of the gold window and the first oil shock in 1973. When he stepped down on August 6, 1979, his successor Paul A. Volcker had to fight double digit inflation with the highest Fed Funds rates seen ever and through his tightening managed to turn the economic downturn into only an on-and-off recession from 1979 to 1982 with GDP never declining more than a quarter in a row.” Greenspan himself had to deal with the stock market crash of 1987 and now Bernanke is faced with his own credit and liquidity crisis. The markets rely on him to be as successful as his predecessors.
[B]Helicopter Ben Showers the Markets with Liquidity[/B]
In response to the crisis, the Federal Reserve and the European Central Bank have collectively added at least $350 billion of temporary reserves into the banking system. It is worth noting that the Federal Reserve was not the only central bank to take this action, as the European Central Bank, Bank of Japan, Reserve Bank of Australia, and the Bank of Canada all enacted similar measures. This is the largest amount of liquidity injection since September 11, 2001. This injection brought interest rates down significantly, helping to give banks a cheap source of funding to meet their financial obligations. To put this into perspective, overnight Federal funds rates have traded as high as 6 percent to below 1 percent in late afternoon trading over the past few days. They are now back at around 5.00 percent. Whenever there is a liquidity problem, ensuring an ample supply of reserves is a central bank?s top priority. This is especially true for Helicopter Ben who earned his title by saying in a speech in 2002 that if interest rates fell to zero in a weak economy, he would drop money from helicopters into the banking system to keep it going. This was in reference to the price phenomenon plaguing Japan at the time, which sparked concerns that slowing inflation in the US could lead to the same situation (for the entire speech, click here).
Bernanke also penned a publication titled, Essays on the Great Depression (2004). One of the key points in his book is that the Federal Reserve essentially caused the Great Depression because they failed to increase the money supply, as a run on the dollar depleted its value rapidly and led to deflation. He certainly lived up to that reputation, but will the liquidation be enough?
[B]Is an Interest Rate Cut Next?[/B]
Although the Federal Reserve refrained from injecting further liquidity into the financial system on Tuesday, they added $7 billion in overnight reserves this morning. It appears that the worst is not behind us and credit markets have not normalized as much as ECB President Trichet indicated yesterday. Central bankers continue to pump money into the system and if the problems in the credit markets continue to exacerbate, which they could once these hedge funds begin to report losses the next option for the Fed would have to be an interest rate cut. Today is what everyone is calling the “red letter day” because it is the last opportunity for investors to request redemptions by the end of September based upon the standard 45 days notice rule. The expectation is that many investors will be looking to withdraw and funds will need to raise cash to meet those withdrawals. With many companies refusing to lend out cash, the only way to raise cash would be through further asset liquidation. Large scale redemptions could continue to weigh on the equity and bond markets in the weeks to come. The markets have already priced in a 100 percent chance of an interest rate over the next 2 months with the possibility of 50bp of easing by the end of the year. An interest rate cut would strip the US dollar of its safe haven status. We do not expect Bernanke to be too reluctant about lowering rates since this may be the only to restore confidence to the markets.

[B]Written by Kathy Lien, Chief Strategist and Terri Belkas, Currency Analyst[/B]