The European Central Bank’s (ECB) job is to set the target interest rate (currently 4%) and then ensure that the market rate (as dictated by banks) does not deviate too far from this. As the attached chart shows, the market rate soared to 0.6% above the target rate yesterday, and the ECB yesterday responded to the credit crunch by injecting almost €95bn of liquidity in to money markets. It’s not unusual for the central bank to intervene in the money markets, but this was the largest intervention since the terrorist attacks on the twin towers. The Federal Reserve also intervened after the US overnight rate reached 6%, way above the Fed’s 5.25% target rate.
Why has liquidity dried up? There have been a series of high profile failures of US hedge funds and European asset backed funds, which has increased end investor and bank nervousness. This has resulted in a less liquid money market, hence reducing money supply, which has pushed rates higher and has forced central banks into action.
The big question is whether this market action is temporary, or whether liquidity needs to be provided on a longer term basis. If the latter, then one can expect rates around the world to start to fall, and for the bear market in government bonds to come to an end.