Expert View: Once upon a time we all believed in the magic of the Fed

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The Independent Online

It took just a few stray words on Wednesday to trigger one of the biggest rallies we have seen in this bear market. They came from Donald Kohn, vice-chairman of the US Federal Reserve, and were not that exciting. There are still enough bulls around to drive such triumphs of hope, desperate to find a Fed cure to the current credit malaise. If only it were that easy. I have an announcement to make: the Fed Put is dead.

Under Alan Greenspan, the Fed acquired an almost mystical reputation. The handling of the Long Term Capital Management crisis was a classic case: jitters were swiftly eliminated by well-timed Fed action. Hence the initial rally this summer when the Fed reversed policy, leading to cries on the trading floor of "the cavalry are here".

In this bullish scenario, the only fear is that the Fed is a little slower than the market likes with the delivery of its magic bullets. Hence the euphoria that greeted Mr Kohn, stating the obvious. He merely pointed out that the Fed had to be "flexible" and committed to ensuring that "when the decisions do go poorly, innocent bystanders should not have to bear the cost". Hardly revolutionary.

But belief in the omnipotent Fed is slow to die. No doubt lighting candles, many bulls daily seek signs that the Fed action is working. Poor guys, US economic statistics are notoriously unreliable and prone to revision. Thursday's strong third-quarter GDP number (+4.9 per cent, revised by some 1.1 per cent from the original figure) was duly seized on. With some correctness, it at least shows the US economy has strong momentum and is benefiting from an export boom (thanks to the dying dollar).

Let's hope. The hard fact, though, is that the US housing market's acceleration towards the buffers shows no sign of being derailed by what the Fed may do. On Thursday we learnt that the fall in house prices was a shocking 13 per cent year on year. In a multi-trillion-dollar market, that's a big number. The current property collapse may soon come to represent one of the greatest destructions of capital in history. Forget all the talk about Main Street decoupling from Wall Street. What is the housing market if not Main Street?

The Fed's magic no longer works. It's up against too much. The credit collapse represents a crisis in investor confidence that cuts to the heart of trading. The "toxic waste" is so widely distributed, and in so many unseen places, that investors are starting to question the solvency of some of the US's largest institutions. This is more serious than LTCM, the savings and loans crisis, or anything else we have seen for many years.

So if we can't rely on the Fed, what can we do? I'll give you three wishes. First, there is the hope that China will power on down its industrialisation path. But beware. Obviously the China story relies on its cheap manufacturing processes flogging goods to the rest of the world not least the US. China's commerce minister points out that a slowing in US growth would represent a significant "turning point" for its own economy. I think he meant "down".

The second bull case relies on a deus ex-machina deployment of capital to ease banking's cash-flow problems. Last week's $7.5bn (3.6bn) shot in the arm for Citibank from the Abu Dhabi Investment Authority was a case in point. There is precedence for this and there is logic. The high oil price is transferring capital from Western economies to Opec members at a rate close to $2bn a day. They are already sitting on immense reserves and in this context a helping hand to some US banks seems chicken feed.

Both of these possible ways out are plausible but they will not provide a solution. Instead, we need to cut to the root of the problem. Where is the toxic waste hiding? If the market knew this, it would be a lot happier. Note HSBC's fessing up last week; will others follow? It would seem sensible for bankers to try. If not, it's just possible that the regulators will give them a helping hand.

It was so comforting when we believed in the Fed Put, wasn't it? Like believing in Santa Claus.