Market Holds Vigil After Rate Cuts

Central banks from the U.S. to Asia sent a resounding message to the markets on Wednesday morning in the first coordinated effort to stem the global financial crisis: We recognize the problem and will respond swiftly and dramatically to help solve it.

The move by at least eight central banks to slash key interest rate targets or voice enthusiastic support for the effort had an immediate impact, with credit markets freeing up dramatically. Stocks wavered in and out of positive territory as investors attempted to gauge the long-term impact of the latest chapter in a wide-ranging government intervention in recent weeks.

The Federal Reserve, European Central Bank and Bank of England each slashed rates by half a point, to 1.5%, 3.75% and 4.5%, respectively. The central banks of China, Canada, Sweden and Switzerland also reduced rates, while the Bank of Japan -- whose rate doesn't have far to fall at 0.5% -- expressed its support.

By Wednesday afternoon, credit markets once again started to show signs of life, as Treasury yields shot higher, the cost of insuring long-term debt plunged, and Fannie Mae ( FNM) issued new notes at a cheaper cost.

"Three major segments of the credit markets are casting compelling signals Wednesday , suggesting glimmers of light are peering through the darkness, and investors are beginning to run toward them," says Tony Crescenzi, chief bond market strategist for Miller Tabak + Co.

But whether those glimmers can be sustained is far from certain, as stresses on the consumer -- whose spending accounts for two-thirds of the U.S. economy -- are sure to take their toll.

Despite the morning's rate-cut news, several groups issued dismal predictions for the economy and financial sector over at least the next year. The International Monetary Fund, in its World Economic Outlook, forecast a "major downturn" in the global economy, with the U.S. slipping into recession. RGE Monitor, which is chaired by the prominent economist Nouriel Roubini, predicted a "full-blown recession in the next few quarters" in the U.S. because policy actions so far have not directly addressed consumer demand or home prices.

Ladenburg Thalmann analyst Richard Bove became the latest to cut estimates on the financial sector, saying that he had earlier believed the U.S. would stave off a steep downturn, but that "events in the financial markets now make it appear to be a certainty that a stiff recession will develop."

The Dow Jones Industrial Average ended nearly 190 points, or 2%, lower, but ranged from a gain of 180 points to a loss of 252 points during the day's session. Investors seemed to be torn between the notions that the government may have taken the first steps into kick-starting an economic recovery and the realization that the moves are far from a cure-all for systemic issues that have swept the global markets.

"Lowering interest rates to unfreeze the credit channel is like lowering the price of Liquid Plumber to unclog a drain," says Rich Yamarone, director of economic research at Argus Research Corp. "It's ineffective and it's not going to get the job done."

"But," he adds, "it's an encouraging sign."

If the intention holds true, lower rates will make the risk-rewards ratio of lending attractive enough to quell some of the distrust and fear that has pervaded the debt markets. Lending is crucial to all aspects of the economy -- businesses need loans to finance operations, which can prevent additional layoffs. Consumers can keep their jobs and acquire loans for homes, cars, education and basic spending.

But while historically effective, those notions are theoretical in the current economic crisis. It is unclear whether bringing down the cost of interbank lending will continue to spur activity, or whether those lower rates will indeed trickle down to cash-strapped consumers.

Barry Bosworth, a senior fellow at the Brookings Institution, and a former economic adviser to President Jimmy Carter, says that although a turnaround will not be immediate, the Fed and other agencies have been responding to the crisis in a remarkable way. He notes that the most successful government responses to crises past first scoop bad assets out of the financial system -- as the Treasury Department's $700 billion rescue plan will begin doing in a few weeks. The second step, he says, is to recapitalize banks, either directly, or by facilitating private cash infusions. The final step is to help jump-start the real economy at the consumer level, once the financial system has stabilized.

"Fundamentally, the problems with the U.S. economy have very little to do with interest rates," says Bosworth. But, he adds, "you would give the Federal Reserve high marks, I think. The Fed has been very good about coming up with innovative ways to pump liquidity into the system. The whole thing has turned out to be much more severe than anyone anticipated."

Indeed, over the past week, the Fed outlined plans to begin buying commercial paper and increasing the size of a program that allows banks to borrow Treasuries in exchange for less-liquid securities and other collateral. However, even in light of those initiatives, as well as the $700 billion financial bailout plan enacted by Congress last week, credit markets had remained frozen until the rate cuts were enacted. The results reinforce the historical trend that a simple rate cut goes a long way in affecting market behavior.

The large-scale government intervention into the financial sector comes as a slew of banks have crumbled, been bailed out or sold on the cheap due to massive strains in the housing and credit markets. Investment banks Bear Stearns and Lehman Brothers have disappeared. Fannie Mae, Freddie Mac ( FRE) and AIG ( AIG) required government bailouts.

The nation's largest thrift, Washington Mutual, failed and parts were sold to JPMorgan Chase ( JPM), while Merrill Lynch ( MER) sold itself on the cheap to Bank of America ( BAC), as its stock came under assault.

Steven Fazzari, a professor of economics at Washington University in St. Louis, notes that although the rate cut seems to have inspired some confidence, it leaves the Fed with less artillery in its bunker. The federal funds target rate had already been aggressively hammered down 325 basis points from the fall of last year through the spring.

"They can't go much lower than that -- they've only got 150 basis points left," says Fazzari. "While I think this is a good move, it's not likely going to be very effective. I don't actually think there is a policy at this point that would prevent a deep recession."

Treasury Secretary Henry Paulson on Wednesday acknowledged that in spite of the government's newly granted authorities and creative maneuvers, "some financial institutions will fail." The housing downturn, and the resulting lack of confidence in mortgage assets and the institutions that hold them, cannot entirely be addressed by government action, Paulson said.

" P atience is also needed because the turmoil will not end quickly and significant challenges remain ahead," he predicted. "Neither passage of this new law nor the implementation of these initiatives will bring an immediate end to current difficulties.