Political Economist

Money markets on Tuesday staged a dramatic reversal of Monday’s flight to safety, after an influential US senator fuelled expectations that the US Federal Reserve would soon cut interest rates.

Christopher Dodd, the chairman of the Senate banking committee, told reporters after a meeting with Ben Bernanke, the Fed chairman, and Hank Paulson, US Treasury secretary, that Mr Bernanke had told him he would use “all the tools” at his disposal to contain market turmoil and prevent it from damaging the economy.

The revelation helped turn around investor sentiment after an earlier warning by Mr Paulson that there was no quick solution to the problems in credit markets.

Mr Dodd said Mr Bernanke also indicated that he was not satisfied with the market’s response to the Fed’s decision on Friday to make direct loans available to banks on attractive terms through its discount window.

The meeting of the three men on Capitol Hill highlights the increasing political pressure on the Fed.

Fed insiders played down the significance of Mr Dodd’s remarks, indicating that there was no change in policy since Friday, when it put out a statement saying it was “prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets”.

The Fed was not expecting market conditions to improve dramatically following Friday’s move, so it will not be too disheartened by the mixed developments since then.

Nonetheless, Mr Dodd’s comments helped sustain a pull-back in the short-term government debt market, where investors had pushed yields down to remarkable lows amid a desperate scramble for safe government paper.

The yield on the one-month Treasury bill showed the sharpest move, rising by 87 basis points to 2.98 per cent by late afternoon in New York, while the three-month bill yield was 43bp higher on the day at 3.61 per cent. Investors had initially poured into short-term government debt yesterday, extending a flight to quality as they shunned the commercial paper market.

The move had pushed yields in the market for Treasury bills around 30 basis points lower, driving the yield on one-month bills below 2 per cent and the three-month bill yield below 3 per cent. The flight to safety had also extended to the two-year Treasury note, which saw its yield fall below the psychologically significant level of 4 per cent yesterday.

In a further sign of investor risk aversion, the pricing differential between higher and lower-rated commercial paper issued by non-financial companies ex­panded to the widest levels since the aftermath of the terrorist attacks on September 11 2001.

“Credit is being repriced, reassessed across our capital markets,” Mr Paulson told CNBC television. “As the Fed addresses liquidity this makes it possible, this makes it easier, for the market to focus on risk and pricing risk. This will play out over time.”

Conditions in equity markets remained tense as convulsions swept through the money and credit markets. By midday in New York, the S&P 500 index was up 0.4 per cent at 1,451.59 while in Europe, leading shares ended the day flat after a late rally.

European shares were weighed down by fresh concerns about the exposure of the German banking sector to turmoil in the US subprime mortgage market.

Underlining the severity of US subprime woes on German banks following the near-collapse of lender IKB this month, Alexander Stuhlmann, chief executive of lender WestLB, said the sector was in a “not uncritical situation” overall.

But shares in Asia continued to rally from last week’s rout. The Morgan Stanley Capital International Asia-Pacific index was up 1.2 per cent in the early evening in Tokyo. This took its rise over the past two days to 5.3 per cent.