Worst of Credit Problem May Have Passed

The Reserve Bank of Australia (RBA) got the ball rolling. Since it started easing its policy in September, the RBA has so far cut by 300 bps. The Swedish Riksbank sliced 175 bps off its policy rate, which was 75 bps more than most investors had expected. The Bank of England followed last month’s 150 bps cut with another 100 bps and I expect the authority to follow up with another 50 bps cut in both Jan and Feb 2009, taking rates to a trough of 1.0%. On the other hand, the European Central Bank (ECB) reduced its policy rate by 75 bps – the largest rate cut the ECB had ever made. The ECB's new pragmatism also came through in Trichet’s answer to the question whether the ECB could engage in "quantitative easing" if need be, that is in simply flooding the banking system with liquidity once it has exhausted much or all of the scope for rate cuts. Trichet pointed out that, with its bold liquidity injections, the ECB has already tolerated a major expansion of its balance sheet.

I expect recession conditions for this quarter and the first half of 2009 will dictate the Fed to ease this month by another 50 bps and a further ease next year is possible. The two-year Treasury will remain below 2% for next year and historically the two year Treasury has served as a good benchmark for pricing private instruments. It will be a key challenge for most investors to search for the new risk/reward trade-off with less credit than what we experienced earlier this decade.

Credit availability is coming back into the market, at least for inter-bank lending. The worst of the credit problem may have passed – at least at the short-end.