Last week, Congress passed the $700 billion rescue package designed to unlock the credit markets. Because modern day politics is what it is, an additional $150 billion in relatively benign sweeteners was added to the package to secure approval. The increase in the FDIC’s guarantee to $250,000 from $100,000 was particularly well received.

Investors however were unimpressed and global equity markets continued to slide. Although Black Monday’s are becoming commonplace of late, yesterday the Dow Jones showed no favoritism and had its biggest one day percentage fall since the 1987 crash.

"The main issue is that commercial banks around the world are hoarding cash. Trust has evaporated. When credit stops flowing, it does not take long for the effects to be felt on the real economy."

As it turns out, the Treasury and the world’s central banks were just warming up. This week, the Fed has announced another raft of new measures designed to unlock the credit markets and reverse the palpable fear evident in markets across the world.

Most importantly, the Fed has created another facility, this time to purchase commercial paper. The commercial paper market is a crucial source of funding for large companies all over the world. To manage cash flows, companies issue short term paper to pay wages, rents, suppliers etc. If this market grinds to a halt, as it has been, then the global economy is in big trouble. To ensure these companies still have access to short term funding, the Fed has now stepped in and will provide unlimited liquidity.

Not to be outdone the UK government stepped up to the plate on Tuesday with a £400 billion rescue package for their banks to get the wheels of lending moving again. The plan equates to a partial nationalization of the sector and will see £50 billion made available in exchange for equity stakes. Also on offer will be £100 billion through the Bank of England’s special liquidity scheme, and a further £250 billion in the form of medium term debt guarantees.

Whilst a different tact adopted in each case, the objective of both America and the UK was the same, to defrost credit markets, and stabilize the financial system.

These moves, whilst significant, were still only part of the solution. Co-ordinated global easing has been missing to date, and Wednesday’s move by central banks around the world will in our view prove a defining punch. The Fed, Bank of England, European Central Bank, Swiss National Bank, Sweden’s Riksbank and the Canadian Central bank all lowered official interest rates by 50 basis points.

We believe this is just the first interest rate salvo. As we explain below, the financial markets are seizing up as investors scramble to the safety of cash. In response, central banks are increasing the opportunity cost of staying in cash by lowering the interest paid. Expect more to come.

The main issue is that commercial banks around the world are hoarding cash. Trust has evaporated and instead of credit flowing in the circular motion that characterizes capitalist economies, it is stagnant. When credit stops flowing, it does not take long for the effects to be felt on the real economy.

We are beginning to see this now with carmakers around the world experiencing plummeting sales. The vast majority of new cars are purchased with the help of credit, and the lack of credit is translating into a lack of demand for vehicles. This is just the most obvious example of how tight credit can impact the economy.

Banks are hoarding cash because liquidity’ is at a premium. When trust amongst lenders evaporates, the default option is to sit on cash. Lending between banking institutions only takes place at very high rates. The chart below shows the TED spread, the difference between three month LIBOR (London interbank offer rate) and Treasury yields, is at historic highs.



US and European banks in particular are woefully undercapitalized.