Signs of a Stabilizing Market

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Stress Test for Credit Markets

Why is the discount rate so powerful? The discount window helps in time of crisis by allowing banks to borrow against collateral considered too risky for most investors. The banks can then reloan the money to consumers, businesses, or investors, helping overcome a liquidity crisis such as the one this summer (see BusinessWeek.com, 7/27/07, "Corporate Debt: Dressed Up, Nowhere to Go").

Of course, there are no guarantees in the markets. The fact that stock prices have increased during previous reductions in the discount rate doesn't necessarily mean they will rise this time. "I am not a prognosticator," says Johnson. "All I can say is that a rise in equity prices would be consistent with previous reactions." Other analysts think it will be some time before it's clear whether the financial markets are stabilizing. "We still don't know whether the environment that existed before Labor Day has started to stabilize or whether it feels like it's stabilizing because people are getting used to it," said Vanessa Spiro, a partner and finance specialist at law firm Jones Day.

Another big question now is whether a stabilizing stock market will help boost confidence in the credit markets. The credit markets will be undergoing a stress test through September as banks figure out whether investors are willing to buy debt used to fund buyouts such as Kohlberg Kravis Roberts' $29 billion deal for information company First Data (FDC) (see BusinessWeek.com, 4/3/07, "When Bad Stocks Make Good Buyouts"). "The markets are all interrelated now," Johnson said in an interview.

The ultimate test for the market will be whether banks such as Citigroup (C) can sell the debt for First Data and other buyouts. If the banks are forced to keep the debt on their balance sheets, they will have fewer resources for making loans, which will exacerbate the credit crunch. But, as Yardeni notes, the banks are likely to press their case with the Fed, putting even more pressure on the central bank to lower rates. That could usher in a period of rising equity prices—if historical trends hold true.

Rosenbush is a senior writer for BusinessWeek.com in New York.