The big question going into 2009 is whether the massive monetary easing by central banks around the world, in which the piece de resistance has been the cutting of the US policy rate to zero, is really working.

Has all that firepower mobilized by the central banks succeeded in thawing the credit markets? Has a modicum of trust and confidence returned after the carnage in October?

Also See Partial Recovery (Graphic)

To answer these questions, let’s take a look at the usual indicators.

The CBOE (Chicago Board Options Exchange) Volatility index aka the “fear gauge" has fallen from a high of 89.5 seen in late October to its current level of around 43, and although that’s still well above the high teens the index had seen during August, the recovery from the October highs has led to many observers assuming that the bottom for the markets is behind us.

One metric that was the focus of much attention when banks had stopped lending to each other was the Libor or London interbank offered rate.

The three-month US dollar Libor, or the rate at which banks lend dollars to each other for three months, had shot up to 4.8% on 10 October but is now down to around 1.46%. That’s well below its rate before the October spike.

Another measure that tracks the rate at which banks are lending to each other is the TED spread, which is the difference between the interest rates on three-month interbank loans and three-month US government debt.

The TED spread had zoomed from around 1% at the beginning of September to a high of 4.6% on 10 October and is now around 1.47%.

Credit default swap indices, however, remain at very high levels. Both the Markit iTraxx Europe index and the North American CDX index are higher than where they were in late October.

But most indicators show that the panic of October has subsided, although not completely. Several measures of risk aversion continue to be at elevated levels.

The yield on the three-month US treasury bill, for instance, is almost zero and the 12-month yield is at 0.3%. That shows investors continue to prefer the safety of government paper. Interest rates on US corporate bonds have come down, but yields continue to remain far above that for government securities.

What about emerging markets?

The spread on emerging market bonds, too, has come down from the heights reached in October, but they’re still way above the levels of August. The yen continues to appreciate, indicating that the carry trade that fuelled the Asian boom shows no signs of returning.

Back home in India, the signals are similar.

For instance, overnight money market rates have fallen considerably, indicating that the credit crunch is over, at least for banks. Banks are now parking huge amounts in government securities.

Interest rates on corporate paper, too, have eased, with the three-month CP rate at 11.6%, compared with a peak of 14.9% in October. But 11.6% for three-month money is still very high.

The spreads on credit default swaps of public sector Indian banks have come down from almost 600 points in late October to about 300 points now, but that’s still higher than the 200-point spread prevailing at the end of July. The National Stock Exchange’s volatility index is around 45 compared with a peak of 85 in November.

All the numbers say there’s been some improvement in the markets since October, but they’re still far from normal.

The indicators will first have to go down to much more reasonable levels. Then they will have to stay there for a considerable length of time before investors start getting the confidence to start coming out of their safe havens.

At the moment, therefore, the first thing we need to see is lower volatility. In the first few months of the new year, therefore, all that we can hope for is a period of calm rather than any revival of risk appetite.

For India, the uncertainty of the elections will in any case continue to dampen sentiment. So, too, should the corporate results, although it can be argued that since everybody expects them to be miserable, perhaps the market has already discounted it.

More importantly, we also need to see signs of a bottom for the economy.

One simple way of doing that is to watch the various Purchasing Managers’ Indices (PMI). These have fallen off a cliff since October and are now deep in negative territory. All indications are that the deterioration will continue in December. But any bottoming out of PMI, which measures expansion/contraction of manufacturing/services from the previous month, will mean the worst is over.

And when that happens and when confidence seeps back, it’s reasonable to expect that very low real interest rates in the US will lead once again to a search for yield abroad, as occurred in Japan.

What happened to all the money created by massive monetary easing and zero interest rates in Japan? It wasn’t enough to pull that country out of the slump, nor did it do much for the Nikkei. But it did lead to the carry trade and the export of that money abroad. Why shouldn’t that happen for the US, too?

The US Fed Reserve has already said that it would leave the policy rate at “extraordinary low levels" for “some time".

This is the reasoning that lies behind the expectation that emerging markets will rise again once the global economy stabilizes. Let’s hope we see that by the end of 2009.

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