Stock markets analysis:Investors have been left reeling but the ECB is in 'strong vigilance mode', writes Simon Barry.
The month of August is traditionally the holiday period of choice for many players in the global financial markets.
The result is usually that trading volumes tend to be substantially below normal levels, and price movements across markets are often confined to relatively narrow ranges.
However, at the end of the first full trading week of August 2007, it is clear that this year's experience could not be further from the norm. Interest rate, credit, equity, bond and currency markets have all been subject to considerable volatility of late. For example, volatility in the US stock market is at its most acute in over four years, as equity prices have swung wildly in recent sessions.
The source of this volatility can be traced to mounting concerns about investor losses in the troubled subprime sector of the US mortgage market, and the knock-on consequences for other markets.
There has been a marked deterioration in the performance of loans to subprime borrowers - households who have low credit scores and either a limited credit history, or histories of payment delinquencies, or bankruptcies - in the US over the past 18 months or so.
The problems have been particularly acute among those borrowers who had taken out variable rate mortgages, often offered at initially heavily discounted rates to ease affordability in the early stage of the loan.
However, many such households have since run into difficulties as they were moved on to higher interest rates once the initial discounts expired. Also, the impact of job losses in the manufacturing sector added to the pressures in some regions.
The percentage of subprime variable rate mortgages classed as delinquent - over 90 days behind in their repayments, or in foreclosure - has more than doubled from under 6 per cent in mid 2005 to over 12 per cent at present.
It is important to bear in mind that the subprime segment accounts for only some 14 per cent of total mortgages in the US.
Thus, while it has been an increasingly important part of the overall market in recent years, a large majority of outstanding mortgages have retained a very healthy credit status. In fact there has been very little if any pickup in delinquency rates of prime borrowers, which remain at historically low levels.
Nonetheless, a prominent theme in markets in recent months has been dealing with the consequences of the problems in the subprime sector.
The indirect effects of this sector's weakness took centre stage this week. In particular, several reports emerged on Thursday that a number of European banks had problematic exposures to financial instruments whose value is ultimately derived from US subprime mortgages.
One such bank temporarily froze a number of funds exposed to the beleaguered sector. While this was not an unprecedented move for a manager of such funds, by that stage the rumour mill was alive with reports of other institutions facing losses and markets quickly became consumed by the dreaded uncertainty factor as fears about the possibility of further losses took hold in a significant way.
Such was the caution among financial institutions that they became extremely reluctant to lend to each other, sparking a seizing up in the money market - the market through which banks engage in the normal practice of transferring funds to one another across the system. Liquidity dried up reflecting the ultra cautious mood and borrowing costs between banks rose sharply as available cash balances were harboured in fear of wider financial system stress.
But, to its credit, the European Central Bank (ECB) was quick to respond. It issued a mid-morning statement in which it stated it was "ready to act" to assure orderly conditions in the money market; and act they did. The ECB injected some €95 billion into the system, which had the effect of returning overnight borrowing costs in the market to normal levels. While such an injection is highly unusual - the aftermath of 9/11 was the last such occasion - the bank's action was exactly what was needed to help restore some order to the market.
The ongoing commitment by the central bank to support the the market is important. This is not just from a liquidity perspective, but also from the perspective of promoting confidence in the market's operation in an environment of heightened uncertainty. Nevertheless, the market remains dogged by the uncertainty factor and the bank injected additional liquidity yesterday, suggesting it may take time for normal activity to resume.
An important question is the extent to which this "micro" problem, in terms of the proper functioning of the money market, will have an impact on the "macro" outlook, and hence on the outlook for ECB interest rates.
We know from last week's briefing from ECB president Jean Claude Trichet that the bank is in "strong vigilance" mode, which means the next rate hike is only a month away.
But, in an interesting development, the editorial of the ECB Monthly Bulletin noted: "Shifts in market sentiment deserve close monitoring. The Governing Council will continue to pay great attention to market developments over the period to come". We read this as introducing an important caveat to the near-term interest rate outlook. In particular, if market conditions remain in a state of disorder then the September rate hike is not likely to be delivered.
Simon Barry is senior economist with Ulster Bank Capital Markets
