Fed's Latest Auction Gets Over Subscribed

A: I'm very busy, so lets just do a quick check on credit markets and the Fed's latest $75Bln auction to banks. Recall, that in easing credit conditions these auctions will receive bids BELOW the limit amount; in this case $75Bln is the total amount being auctioned by the fed. When we had an auction receive only $35Bln or $40BBln in bids, the market would interpret that as the credit markets easing and a sign that the banks did not need the capital being offered to them during the credit crisis. However, this latest auction was oversubscribed with a total of $89Bln worth of bids coming in for an auction totaling $75Bln; a clear sign that the credit crisis continues behind the scenes.

From CNN Money's, "Fed Auctions $75Bln To Banks":

In the latest auction, commercial banks paid an interest rate of 2.360% for the short-term loans. There were 76 bidders for the slice of $75 billion in 28-day loans. The Fed received bids for $89.38 billion worth of the loans. The auction was conducted on Monday with the results released on Tuesday.

With commodity inflation surging, the fed has relied more on these short term facilities to ease the credit crunch over cutting the fed funds rate further; which would fuel further run ups in commodities and pressure the dollar to the downside. We are about to enter a period where headline inflation is likely to surge; as the seasonal adjustment element of inflation reporting is taken out.

Checking into the ABX indexes, I see a significant decline over the past few weeks signaling investors' fear of rising defaults resulting in the potential of more writedowns for securities of these loans. Here is MARKIT's AAA ABX Index, showing us below the level hit in early March before Bear Stearns failed:



By now, I think most have awaken to the reality that this credit crisis is not just a random and short-lived event. The problem we are about to face is one that the blogosphere has been discussing in depth for many months; inflation at a time when economic weakness remains. What is a fed to do? If the data on inflation really gets hot, at the same time that unemployment is rising and growth weak, it doesn't even matter what the fed does because the bond market will likely price future moves in on its own. That in and of itself will cause some pain without the fed even hiking rates; and to an extent this has happened over the past 3-4 weeks.

Anyone who checked mortgage rates recently knows what I am talking about. Anyway, corporate spreads still seem to be OK and LIBOR is not showing any serious signs of distress, so for me, its more of the same in terms of the credit markets; housing/debt continues to be pressured as defaults and foreclosures are rising and spreading to higher quality debt classes. HELOC's are a growing problem. This credit storm is clearly coming in waves and while the worst may be behind us, we are not out of the woods yet!

As for the fed, I think the bond market is getting a bit ahead of itself in pricing in rate hikes. I do not think it will come as fast as some think, as long as economic data continues to be weak. However, the medium term forecast for fed funds rate (especially after the election) is definitely biased towards the upside. In short, we will have to deal with the pain of rate hikes to combat the coming inflation problem.