Source: Bank of Iceland

In recent weeks, money market rates have risen in both Europe and the US, as banks remain ultra cautious on lending, raising fears that the recovery in equity markets in the past week, may not signal an easing of the credit crisis. Meanwhile, Iceland raised its benchmark interest rate to 15% on Tuesday and in the US, the broad-based S&P 500 index closed at a nine-year low.

Despite efforts by central banks to improve liquidity in money markets, the situation is getting worse.

Euribor rates hit their highest level in 2008 on Tuesday and the European Central Bank allocated €216bn in seven-day funds in its regular weekly operation - €50bn higher than the amount it estimated would have normally been required - at an average rate of 4.28%, which was the highest since late September.

The Euribor three-month rate - a key rate used in commercial lending - increased 3 basis points to 4.7% (4.699%), the highest level since Dec. 27th and its 14th straight rise, the European Banking Federation said today. The one-week rate rose 4 basis points to 4.31% (4.315%), also the highest since Dec. 27th.

In London, the three-month Libor rate rose to 5.995% and like its Euro counterpart, was also the highest of the year. The rate is almost 0.9% above the level investors demand for risk-free money.

In Washington on Tuesday, the Fed’s latest lending to banks under its Term Auction Facility received bids for $88.9bn compared with the $50bn on offer, an excess that was almost as great as the previous auction two weeks ago, before the collapse of Bear Stearns.

Euribor - Euro Inter-Bank Offered Rate - money rates hit highest level in 2008 today; Rise of 3-month rate equivalent to almost 3 ECB interest rate hikes

In Europe Tuesday, stock prices rose sharply and the Dow Jones 600 closed up 3.2% with all 17 Western European markets that were open for business, rising.

The Dow Jones Industrial Average snapped a three-day winning streak, losing 16.04 points, or 0.1%, to close at 12532.60, down 6.1% on the year.

The Standard & Poor's/Case-Shiller Index published on Tuesday showed that US home prices fell 11.4% in January, the steepest plunge since data was first collected in 1987. The index tracks the prices of single-family homes in 10 major metropolitan areas in the US The broader 20-city composite index also declined, falling 10.7% in January from a year ago.

S&P/Case-Shiller Home Price Indices: Record falls in US Home Prices continued in 2008; Las Vegas and Miami reported double-digit annual declines of 19.3%, followed by Phoenix at -18.2%

The US Conference Board Consumer Confidence Index, which had declined sharply in February, fell further in March.

The Expectations Index, is now at a 35-year low (Dec. 1973, 45.2), levels not seen since the Oil Embargo and the Watergate Scandal during the Nixon Administration.

US Conference Board Consumer Confidence Index plunges in March; Expectations Index declined to the lowest level since 1973 when Richard Nixon was President

US Housing Crisis

Robert Shiller, Professor of Economics, Yale University

Yale University economist Robert Shiller, co-founder of the Case/Shiller Index (see above) and a forecaster of the market bust in his 2000 book Irrational Exuberance, does not expect US housing woes to end soon.

"I have to say that this isn't a great time to be in the stock market," Prof. Shiller told the Wall Street Journal. "The housing crisis that we are going through is going to put a damper on the economy that is longer than a recession. I don't see the stock troubles ending as quickly as many people are imagining."

Prof. Shiller sees home values continuing to weaken for years. He expects consumers to borrow and spend less, and to rebuild their savings.

Daniel Gros, Director of the Centre for European Policy Studies in Brussels, writing in the Financial Times today, highlights an  important difference between the US and European mortgage markets: "...in the US, most mortgages are “no recourse”, which means that the lender (the bank) has no recourse to the owner of the house. If the value of the house is lower than the mortgage on it the borrower can just walk away and simply send the keys to the bank. This is called “jingle mail”, and it is becoming more common throughout the US as house prices are declining almost everywhere.

This “no recourse” nature of US mortgages means that a fall in house prices leads to severe problems for the banking system because mortgages still make up almost half of all lending by US banks. By some estimates the US banking system might lose all of its capital if house prices were to fall by 20-25 per cent, as they must if they are to go back to average pre-bubble valuations.

In Europe borrowers cannot just walk away from a mortgage, since they remain liable for any difference between the value of the property and the amount of the loan. In Europe a fall in house prices may make consumers poorer and less willing to spend, but it does not threaten the stability of the banking system."

Standard & Poor's 500-stock index at 9-year low

The Wall Street Journal in an in-depth article today titled, Stocks Tarnished By 'Lost Decade' - U.S. Shares in Longest Funk Since 1970s; Credit Crunch Could Prolong Weakness, says that the Standard & Poor's 500-stock index, the basis for about half of the $1 trillion invested in U.S. index funds, finished at 1352.99 on Tuesday, below the 1362.80 it hit in April 1999. When dividends and inflation are factored into returns, the S&P 500 has risen an average of just 1.3% a year over the past 10 years, well below the historical norm, according to Morningstar Inc. For the past nine years, it has fallen 0.37% a year, and for the past eight, it is off 1.4% a year. In light of the current wobbly market, some economists and market analysts worry that the era of disappointing returns may not be over.

The Journal says that over the past nine years, the S&P 500 is the worst-performing of nine different investment vehicles tracked by Morningstar, including commodities, real-estate investment trusts, gold and foreign stocks. Big U.S. stocks were outrun even by Treasury bonds, which historically perform much less well than stocks. Adjusted for inflation, Treasurys are up 4.7% a year over the past nine years, and up 5.8% a year since the March 2000 stock peak. An index of commodities has shown about twice the annual gains of bonds, as have real-estate investment trusts.

Iceland raises interest rates to 15%

On Tuesday, fears grew that Iceland could become the first country to be hit by a severe economic crisis triggered by fallout from the credit crisis.

The Bank of Iceland in an emergency move, raised the benchmark interest rate 1.25 percentage points to 15% in an effort to restore confidence in its stumbling currency.

In Ireland, another open economy that is strongly dependent on foreign investment, some economists have the luxury of aching for a Eurozone recession to prompt the European Central Bank (ECB) to cut its benchmark rate from its current level of 4%. It would be a very different story without the protective embrace of the ECB and the Euro system.

The Bank of Iceland said on Tuesday that the “deteriorating financial conditions in global markets” had contributed to the emergency move. Fears that imbalances that resulted from a boom, which prompted Icelandic companies to invest heavily overseas in recent years, may trigger a collapse of the banking system, has pushed the króna down by 22% in 2008.

The central bank said Iceland faced “spiralling increases in prices, wages and the price of foreign exchange”.

The rise in the interest rate triggered a gain for the  króna of 6.3%  against the dollar, while the country’s benchmark stockmarket index recorded its biggest rise in more than 15 years, jumping 6.2%.

Monetary policy statement by the Board of Governors of the Central Bank of Iceland:

The Central Bank of Iceland raises its policy rate

The Board of Governors of the Central Bank of Iceland has decided to raise the policy rate by 1.25 percentage points to 15%. The assumptions underlying the inflation forecast published in Monetary Bulletin in November 2007 entailing an unchanged policy rate until after the middle of this year have not held.

Inflation has been higher than forecast and inflation expectations have risen. Demand has also been stronger than was expected. The exchange rate of the króna has depreciated more than entailed in an alternative scenario published in Monetary Bulletin in November. It assumed that such a development would be met with a higher policy rate. The real exchange rate of the króna is now very near a long term historical low which it reached in November 2001. If that development is not reversed and a period of persistent inflation would be ahead with spiralling increases in prices, wages and the price of foreign exchange. The depreciation of the króna in recent weeks also undermines the Balance Sheet of indebted households and businesses and thus financial stability looking further ahead. It is therefore crucial that the depreciation of the króna is reversed as quickly as possible.

Deteriorating financial conditions in global markets mean that it has become more difficult to finance current account deficit. Adjustment of the national economy with a contraction of demand will thus be not escaped. It will only be more painful if inflation if inflation is allowed to get out of hand. Consequently, it will be necessary to continue to pursue a very tight monetary policy in order to bring inflation and inflation expectations under control and increase confidence in the króna.

On Thursday April 10, the Central Bank of Iceland will issue its Monetary Bulletin with a new national economic forecast and an inflation forecast. At the same time the Board of Governors will announce its decision on interest rates.