STOCKS SURGED and bonds fell in early trading yesterday after the US Federal Reserve took its most radical step yet to reverse liquidity strains in financial markets, backed up by smaller moves from other central banks.
In its second big intervention since Friday, the US central bank announced that it would lend primary dealers in the bond market up to $200 billion (€131 billion) in Treasury securities for a month at a time and accept ordinary AAA-rated mortgage-backed securities as collateral in return.
The latest Fed move is designed to ease liquidity strains in financial markets by allowing primary dealers to swap their mortgage-backed securities for Treasuries, which they can in turn use to raise cash.
Analysts said it took the US central bank a step closer to the nuclear option of buying mortgage-backed securities in its own right, although it stopped clearly short of such an extreme move.
The Fed, the European Central Bank (ECB) and the Swiss National Bank also announced that they were increasing the size of currency swaps put in place in December by 50 per cent.
The two European central banks said they would auction the dollars supplied by the Fed in the form of one-month loans, with the ECB offering $30 billion and the Swiss National Bank $6 billion, creating an enhanced offshore supply of dollars for financial institutions based in Europe.
The Bank of Canada and the Bank of England also announced extensions to their liquidity support operations.
The Fed's action follows Friday's announcement that it was increasing the size of its loan auctions to $100 billion and offering another $100 billion in one-month repurchase agreements.
In a note to clients, Goldman Sachs said: "This announcement makes it clear that Fed officials are pulling out all the stops they can think of to deal with financial stress through the increased provision of liquidity into the system."
The initial reaction across all markets was euphoric, with shares surging, bonds falling, the dollar rallying and the cost of credit insurance falling.
However, as the day progressed the impact abated in several markets, leaving credit conditions improved but still strained.
Stocks soared in the first hour of trade, with the S&P 500 up 2.3 per cent. By mid-afternoon it was still 2 per cent up on the day, although it had fallen back at lunchtime.
Money markets showed signs that traders expected the new lending facility to ease funding pressures, with a 15 basis-point decline in the rate banks charge each other for three-month dollar loans to 2.87 per cent.
