Just another manic Monday

Yesterday marked the seventh trading session since Fed chairman Ben Bernanke’s decision to meddle in the markets via the Fed’s discount window. It has become clear that, rather than seeking to exert direct upward pressure on the markets, the Fed’s intervention was mainly a PR exercise designed to demonstrate to bankers that the Fed was growing sensitive to their troubles (the hope being that this would restore some measure of trust in the credit markets). If this is so, has the intervention worked?

In a strict and short-term sense, the answer is yes. In those seven sessions since the Fed announcement the Dow Jones Index has gained over 650 points, or close to five percent. By contrast, the Index was down nearly four percent in the seven sessions prior to the announcement (and had posted six straight days of decline). A better measure might be the trading ranges during each session. Before the Fed intervened, we would see on a daily basis wild swings—ecstatic rallies and quick crashes—not unlike the metabolism of a caffeine addict. Since the intervention, the intraday ranges have been markedly smaller; Monday’s range was about 70 points, not the 200- and 300-point ranges of earlier this month.

All of this would seem to indicate that the market is trading less on emotion now, which is a good thing. In effect, the Fed’s aspirin tablet did have immediately ameliorative effects, both on the equity markets and credit markets. We’ve even seen a few deals consummated. So, yes, in the short term, the Fed’s strategy has worked.

In the intermediate to long term, however, there are still serious problems in the credit markets, and these problems will not be solved through the Fed’s discount window. The usefulness of the Fed’s intervention, aside from its palliative effects, is that it provides bankers with time to assess their exposure to this mess, and hopefully, there will be enough banks out there that judge themselves sufficiently protected (at least, enough so to resume business as usual). But there will be some players burned badly, more so than the current roster of failures, so third-quarter earnings statements will be watched carefully, and of course, the actions of the banks themselves will be watched closely for hints and clues as to the overall health of the banking industry. If enough banks determine that their health has been compromised beyond their level of tolerance, this diagnosis will likely spill over once again into the stock market, and we will see the market decline.

And, of course, even in the rosiest scenario we could dare imagine—namely, that all of this just blows over like an electrical storm—there will be a greater risk of larger crises in the future, as the lesson many will take from this crisis is that the Fed will bail out those who have taken on excessive risk.