Subprime: The Ugly American Hits Europe

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Betting on Rate Cuts

How will this play out in financial markets? Equities plunged Thursday morning, with major European indexes skidding and the Dow Jones industrials down 205 points in afternoon trading. Bond yields fell as investors flocked to the relative safety of government debt.

Fed funds futures, a vehicle for market pros to bet on future interest-rate moves, rallied sharply Thursday in early U.S. trading. Futures prices now imply 100% odds of a quarter-point rate cut by the Fed at next month's FOMC meeting, with a similar-sized cut seen as increasingly likely by the end of the first quarter.

The problem, in Europe as in the U.S., is how markets, banks, and policymakers can ever hope to get their arms around the true size of the U.S. subprime crisis. S&P strategist Alexander Young says that given the illiquid, opaque nature of many of the funds and CDOs that hold this subprime paper, the extent of this problem is very difficult to gauge. "This creates ongoing uncertainty and is heightening equity volatility," he says.

A Question of Confidence

Market observers in Europe have little doubt that the ECB will turn the spigot back on Friday and beyond, if needed. The ECB has displayed firepower before: On Sept. 12, 2001 it did a €70 billion ($96.5 billion) tender to provide liquidity in the wake of the World Trade Center and Pentagon attacks. "The ECB is doing exactly what a central bank should do in these circumstances," notes Gabrial Stein, chief international economist for Lombard Street Research in London.

The question is whether an isolated, albeit large, problem—the liquidity shrinkage prompted by the subprime crash—metastasizes into something harder to contain. "It's a question of confidence,"says Charles Diebel, head of interest rate strategy for Nomura Securities in London. "There's plenty of cash out there, but there are a lot of small fires burning."

With Kerry Capell and Andy Reinhardt, and reports from Standard & Poor's MarketScope and Action Economics staff