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Investors shaken by bank troubles

17/03/2008 - 7:05

By Jeremy Gaunt, European Investment Correspondent

LONDON (Reuters) - Stalked by the credit crisis and economic decline, investors enter this week with eyes firmly on the Federal Reserve and braced for more trouble in the shaky financial sector after Bear Stearns had to be bailed out.

A raft of U.S. broker banks will report first quarter earnings while the Fed is poised to cut interest rates.

The question will be whether anything will reverse increasingly entrenched trends on financial markets that include a tumbling dollar at record lows, stock markets selling off sharply and oil and gold soaring to record highs.

All are in turmoil as U.S. recession appears more likely, if not already here, and a credit squeeze has claimed victims ranging from hedge funds to securities trading and brokerage heavyweight Bear Stearns .

"People are losing confidence in the decoupling story, that the rest of the world would grow and the United States would slow," said Stephen Dowds, head of international equities at Northern Trust Global Investments.

"The risk scenario has changed from being an inflationary one to being a significant global slowdown," he said.

JPMorgan Chase & Co and the Federal Reserve Bank of New York agreed on Friday to provide secure funding for Bear Stearns after a deterioration in the latter's liquidity, part of a broad-based drying up that has been going on since mid-2007.

The cost of protecting debt at rival Lehman Brothers also jumped.

Accordingly, investors this week will be scouring the first quarter earnings reports of Goldman Sachs , Morgan Stanley , Lehman and Bear Stearns itself.

As one market player only half-jokingly put it, investors may be looking less at how profitable the investment banks are than at how far they can afford to pay their writedowns from the credit crisis.

Bear Stearns, of course, was not the only credit crisis victim last week.

Investment house Carlyle Capital Corp said it expected its lenders to seize its remaining assets after failing to reach a deal with creditors. Advisors Drake Management told investors it was considering liquidating all three of its hedge funds with $5 billion of assets.

Although ratings agency Standard & Poor's said writedowns for large financial institutions are probably past the halfway mark, the fear remains on markets that there is much more damage to be reported.

"Nobody can say where the end is," said Philipp Baertschi, equity strategist at Bank Sarasin in Zurich.

As well as writedowns, investors will want to see how investment banks have been faring in mergers and acquisitions and brokering, he said, adding that there is also concern about a profits slowdown outside of the financial sector.

FED WATCH

The Fed's interest-rate setting committee, meanwhile, meets on Tuesday with the issue for investors being not whether it will cut rates but by how much.

Futures markets are pricing in a near certain 75 basis point cut to 2.25 percent and a growing chance of a full percentage point to 2.0 percent. This would follow the surprise 75 basis point cut on January 22 and a further 50 basis points on January 30.

In addition, the Fed has led further central bank efforts to pump liquidity into drying up markets, including last week's decision to allow financial firms to swap securities backed by home mortgages for some $200 billion in Treasury bonds.

The problem is that there is little evidence that the moves have worked in a sustained way.

Last week's security swap move, for example, initially led to the biggest daily gain in the S&P 500 U.S. share index <.SPX> since 2002 and also boosted the dollar. But it was short-lived euphoria, especially in the rest of the world.

"There is definitely a danger that it is not working, or that it is not working as well as it did before," said John Ip, senior economist at Morley Fund Management.

Ip noted that yields on triple-B corporate bonds, those at the bottom end of investment grade, were actually higher than when the Fed began to respond and rates for 30-year U.S. mortgages were essentially unchanged, suggesting little impact from turning on the liquidity tap.

The contrary argument, of course, is that without any action things would be far worse.

But while there is no guarantee that equities will respond with a rally after the expected Fed rate cut, the dollar is likely to remain under immense pressure.

Lower U.S. interest rates have combined with weakness in the U.S. economy to batter the dollar, which last week hit a series of lows against major currencies.

This included dropping below 100 Japanese yen for the first time in 12 years and hitting all time lows against the euro beyond $1.56.

This weakness has also driven oil and gold prices to record highs -- the former to more than $110 a barrel and gold to more than $1,000 an ounce.

The latter is hardly surprising given what has been happening on financial markets. It is nearly always seen as a traditional safe haven in times of trouble.

(Editing by Ruth Pitchford)


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