The sudden and massive 75 basis points’ cut in interest rates to 3.5 per cent by the US Federal Reserve sharply highlighted the severe threat of recession in the United States. The US central bank’s move is a desperate attempt to avoid a significant economic downturn in both the US and global markets.
Substantial falls in equity markets worldwide placed pressure on the Fed to act quickly and decisively. Recent figures highlighting a worsening of the US housing market downturn and higher unemployment levels gave further cause for concern. Financial market conditions have continued to deteriorate and credit has tightened further for corporates, businesses and households.
The short-term risk is a noted downturn. The US market was braced for a substantial fall prior to the Fed’s announcement. It plunged by 450 points in the opening minutes but then recovered. In the end, the market declined by one per cent the day the cut was announced.
Despite the action, data from some sources suggest the US economy is already in recession. The Fed’s action certainly took markets by surprise. The last time the Fed undertook an emergency cut was following the September 11, 2001, terror attacks. From problems in the US sub-prime market, which have steadily increased over the past 12 months, to the severe squeeze in the global credit markets, investors now fear that economic contagion will occur. The engine of the world economic growth has been the US consumer. Fearing a slowdown, markets have suffered.
Worsening the situation is the fact both the economy and investment markets feed off each other.
Markets largely disconnected from the US have been hit. Australia, for example, which is still enjoying strong economic growth on the back of commodities and resources, lost 400 points on Tuesday, and is down by 18 per cent for the year, and 20 per cent from its peak, signifying a bear market.
Until now most analysts believed China’s seemingly insatiable demand for mineral exports would protect the Australian economy and its share market from the fallout from the US sub-prime mortgage crisis. The market is now facing a harder hit to the Australian economy from a US recession than first thought. This scenario is now being played in other leading global markets, from the United Kingdom to the Gulf to India and China. Most Asian markets experienced their worst fall for eight years.
Although some have labelled the Fed’s decisive move as panic-led, it was necessary and is hard to criticise. The danger was more to do with delayed interest reductions, and staggered decreases. The Fed had already fallen behind the curve in regard to monetary policy.
Some would say other central banks, such as the Bank of England, have done the same.
The stimulus package in the US to date had only received a lukewarm reception from markets, and in part this influenced equities in Asia and elsewhere reliant on US demand.
Markets remain volatile and weak. There remains uncertainty about the extent of losses connected to US sub-prime exposure. Many analysts believe banks have still not fully disclosed losses in sub-prime assets.
The extent of the US slowdown will dictate the effect on other export-led markets. Commodities and resources may also be dragged down, reflecting falling demand. The Federal Reserve, and other central banks, are likely to continue to cut market interest rates in an attempt to restrict the severity of the downturn.
The latest to reveal losses is Bank of America. The onset of a recession in the US is highly likely now. Earnings in Western markets will be hit. Underlying fundamentals are still deteriorating.