In an unprecedented move on Friday morning, Treasury Secretary Henry Paulson announced several measures to help stabilize the markets. We feel that each of these measures is beneficial for market stability and short-term equity market recovery. We also believe that the full implications of these steps are unknown at this point. The details are not fully out to the markets and there are many questions as to the cost and ultimate impact in the coming months.
These steps come on the heels of some of the most significant market shifts in the last 50 years. The failure of Lehman Brothers, the merger of Merrill Lynch with Bank of America, the rescue package for AIG, and this Friday’s announcements are truly monumental, historical, and, in many ways, unprecedented.
The reaction from the markets has been very positive, with stock prices in the Us and worldwide surging. Whether this is a sustainable rebound or simply a huge bottoming rally will remain to be seen. In the Treasury markets prices are, of course, falling dramatically (higher yields) as the “flight to quality” trade finally begins to show rational behavior. The Treasury market has experienced both its historic rally and sell-off this week. The 10-yr moved from 3.4% to over 3.75% in Friday’s early trading activity. The 3-month T-bill, which has actually gone to negative yields as investor demand peaked, traded up almost 75 basis points in the first few hours of Friday morning.
At the very least, we expect volatility to continue in the near-term. The recommended measures were overdue, but certainly welcome. However, they are not free and they do not provide an easy fix to Wall Street woes. It took many years to get to this level of excess, and it won’t be over with a wave of the pocketbook from Washington. The current turmoil and crisis is clearly an event driven by a lack of confidence in the financial system. That confidence has now been restored – at least for now. On the downside, the costs will be immense and the moves debated for years to come. Already chiming in is John Bogle, founder of Vanguard, who stated, “We’re playing a game of casino capitalism, interfering with the way the market is working. The government seems punch drunk. It doesn’t seem systematic.”
Following is a brief summary of Friday’s announcements:
Money Fund Insurance
The US Treasury plans to use as much as $50 billion from the country’s Exchange Stabilization Fund to temporarily protect investors from losses on money market mutual funds. The Treasury will insure, for one year, holdings of publicly offered money market funds that pay a fee to participate in the program. Retail and institutional funds are eligible, the department said today in a statement. What is not known are the fees and costs to this program to the funds, and also how the plan is to be executed. This move was put in place to stop money market mutual funds from having “runs” on their asset bases as institutions moved to short-term Treasury securities. The Investment Company Institute reported on Friday that $169 billion had left money funds, with the vast majority of that being institutional players, not retail investors. In addition, there have been reports of near failure at several new funds, including the Putnam Institutional Prime Fund, which was closed and is now in process of liquidation.
Given the vital role that money market funds play in the smooth functioning of the overall credit and capital markets, as well as the retail panic more fund failures might have provoked, we think this move stabilizes the money fund industry, and money market funds in general, and provides a level of confidence that was needed to maintain pricing valuations.
Ban on Short Selling Financials
The SEC announced a temporary ban on the short-selling of financial companies’ shares until October 2. The UK took a similar step on Friday. The list of US firms includes 800 companies. The SEC and the New York Attorney General’s office announced the start of investigations into whether investors illegally drove down the stock prices of financial firms. Additional SEC rules also took effect to halt manipulative trading. These rules address the options market regulations governing the prompt delivery of borrowed shares, impose penalties on brokers if their clients haven’t delivered shares to buyers three days after a short sale, and make it a fraud for investors to lie to brokers about locating shares to be sold short.
A New “RTC”
Treasury Secretary Paulson also announced that US officials will establish a fund, reported to be $800 billion, to purchase failed loan assets. On Friday morning, Paulson described two steps:
First, to provide critical additional funding for the mortgage markets, the GSEs Fannie Mae and Freddie Mac will increase their purchases of mortgage-backed securities (MBS).
Second, to increase the availability of capital for new home loans, Treasury will expand the MBS purchase program announced earlier this month. This will complement the capital provided by the GSEs and will help facilitate mortgage availability and affordability.
“These two steps will provide some initial support to mortgage assets, but they are not enough. Many of the illiquid assets clogging our system today do not meet the regulatory requirements to be eligible for purchase by the GSEs or by the Treasury program,” said Paulson.
Over the past several days the Federal Reserve added tremendous liquidity to the market. According to the Fed, “The Federal Open Market Committee has authorized a $180 billion expansion of its temporary reciprocal currency arrangements (swap lines). This increased capacity will be available to provide dollar funding for both term and overnight liquidity operations by the other central banks. The FOMC has authorized increases in the existing swap lines with the ECB and the Swiss National Bank. These larger facilities will now support the provision of US dollar liquidity in amounts of up to $110 billion by the ECB, an increase of $55 billion, and up to $27 billion by the Swiss National Bank, an increase of $15 billion. In addition, new swap facilities have been authorized with the Bank of Japan, the Bank of England, and the Bank of Canada. These facilities will support the provision of U.S. dollar liquidity in amounts of up to $60 billion by the Bank of Japan, $40 billion by the Bank of England, and $10 billion by the Bank of Canada.”
The amount of money infused to the system is staggering but needed in the near-term. Longer term it may disrupt the normal operations of monetary control and, of course, could be quite inflationary in nature.
Kanaly Trust’s Investment Strategy
We believe the equity markets reached an important low Thursday morning as panic set in. Trading volume set records on successive days in excess of 10 billion shares and the Volatility Index reached a level (42) not seen since the market bottomed in 2002. However, major market bottoms are almost always retested prior to starting a bullish trend, meaning we should eventually revisit yesterday’s lows. We expect the market to rally a limited amount from here (5%-7%) as short positions are covered, allowing an opportunity to raise additional cash. Should the markets successfully retest the lows, we would have more confidence that a market bottom has been reached and would consider a more aggressive allocation to equities at that time.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts.
There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.
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