Experienced investors know that most economic recoveries occur slowly, almost imperceptibly, kind of like the arrival of dawn.
Case in point: The three-month Libor, or London interbank offered rate, which dipped below 0.50 percent for the first time Friday since the financial crisis began last fall, providing additional evidence that major central bank efforts to loosen credit markets are working.
The Libor and related rates are sometimes overlooked but they hold the clues to the health of the credit markets. In particular, the three-month Libor is a benchmark for about $360 trillion in financial products world wide. The rate peaked at 4.82 percent in October 2008, during the financial crisis' acute stage.
In addition, the Libor-OIS spread, an indicator of banks' willingness to lend, totaled 31 basis points on Monday; back in October 2008 it hit a high of 364 basis points.
For those investors not as familiar with the credit markets and their role in finance, here's an analogy: think of the credit markets as the interstate highway system of finance. Most drivers know what can happen if a key highway becomes blocked: traffic slows and then backs up. Likewise, with credit markets: during the financial crisis, a lack of lending, capital shortages, and outright fear slowed credit down, and created bottlenecks, making it harder for businesses to access credit for commercial operations and investments. On two occasions, the global financial system almost ground to a halt.
Largest central bank action since 1930s
Over the last eight months, the financial markets have been inching back toward normalcy, and it's no coincidence or random process. It's the result of a concerted, non-traditional effort by the U.S. Federal Reserve and the world's other major central banks. The Fed alone has pumped more than $10 trillion into the financial system, with the Fed's companion central banks, the European Central Bank, Bank of England, Bank of Japan, and Swiss National Bank, also deploying both monetary and non-traditional tools to re-liquefy credit markets. It's the largest, coordinated central bank intervention since the 1930s.
Still, the effort by the major central banks is hardly perfect. One flaw often cited by critics: the major central bank efforts have been designed to liquefy credit markets in which institutional investors -- hedge funds, investment funds, and pension funds, among others -- dominate. As a result, the actions will have the effect of bolstering if not rewarding some of the institutions that helped create the financial crisis in the first place.
To some people, this represents an injustice, and it's a valid criticism. But absent a wholesale change in the U.S. financial system (and the international financial order), the Fed was compelled to work with the stakeholders in the current system. The tactic is likely to draw criticism and review for years, if not decades, from populists who view it as favoring the fat cats in the big money institutions. Still, at the end of the day, the reality is that these institutional investors account for more than 50 percent of the money for bonds, commercial and related instruments that help corporations fund daily operations, pay suppliers and meet payrolls. Simply, commercial operations could not function without the involvement of institutional investors.
Monetary Analysis: The major central banks' effort to end the two-year freeze-up in credit markets is working, but we're only about half-way home. While maintaining current liquidity actions, the Fed and other central banks must now re-double efforts to work on the front end -- i.e., programs that encourage banks and other lenders to make more credit available, particularly for medium and small businesses.
After the financial crisis has ended and a sustained economic recovery is underway, officials can review the mistakes made, investigate and punish guilty parties. But investors should understand, it isn't appropriate for the Fed or other central banks to undertake that task, so long as the fate of credit markets is at stake.
Financial Editor Joseph Lazzaro is writing a book on the U.S. presidency and the U.S. economy.
Learn the most important step in structuring an investment portfolio.View Course »