Spreading Infection

The near-panic about subprime mortgage problems seemed to be fading this week, with three days of strong gains bringing the benchmarks nearly halfway back from their losses. All that changed today when a large French bank reported that some hedge funds it sponsors may have experienced major losses in mortgage securities. A problem that appeared to be mainly restricted to the U.S. suddenly started to look like a global crisis. The European Central Bank injected liquidity into the market on a massive scale, but overnight interbank lending rates still soared.

Meanwhile, there were signs in the U.S. that financing problems may derail some of the recent private-equity transactions that have propped up stock valuations. Home Depot (HD) scaled back plans for a stock buyback. Risks are growing for corporate bonds as banks tighten their credit standards and ratings agencies place many bonds under review. Treasury bonds again rallied as capital from around the globe sought a safe haven. Falling crude oil prices again cut into energy sector earnings, removing one of the market's recent leaders.

There is growing concern that the Federal Reserve may have erred by declining to reduce interest rates at its meeting earlier this week. Ben Bernanke has consistently argued that Fed policy decisions should be made slowly and deliberately, not in reaction to market events. With energy prices at historically high levels, the Fed does not have a lot of room to maneuver right now if it wants to keep inflation under control. Nonetheless, the futures markets now indicate a near 100% consensus that the Fed will cut rates in October.