U.S. awaits markets’ verdict

The federal government now has thrown nearly everything it has into reversing the credit crisis and stabilizing financial markets.

This week, investors will deliver their verdict on whether this enormous intervention was enough -- or maybe too much.

The Bush administration and the Federal Reserve desperately need the markets to react positively in the next few days. If they don’t, investors’ loss of confidence could be catastrophic because of the sense that there are no more bullets left in Uncle Sam’s gun.

And given our debtor-nation status, Americans’ views of this debacle may matter less than what foreigners think. We still live, to a large degree, on their euros, yen and riyals. The mother of all credit crunches still is out there -- the one that would be sparked by the wholesale flight of foreign investors from our stocks, bonds and money market IOUs.

In the near term, one risk is that many market players will find it too difficult to sort out the ramifications of the government’s multipronged effort and will simply withdraw.

The scale of the rescue program “is bewildering to a Wall Street professional and must be overwhelming for an ordinary investor,” said David Kotok, head of investment firm Cumberland Advisors. “It is disconcerting and unfathomable on Main Street.”

The Treasury is committing $700 billion of taxpayers’ funds to buy up “troubled assets” from financial institutions. But which troubled assets -- and which institutions? How much of a markdown will the government demand on the assets, and how will that affect investors’ perception of the garbage banks will keep on their balance sheets?

Wall Street has a telephone book’s worth of questions about the debt-buyout program, and very few answers.

Investors’ usual response to uncertainty is to cut the level of risk in their portfolios -- such as by selling stocks and hoarding cash. The U.S. is betting that its massive intervention program will do more to reduce uncertainty about the future than to increase it, but that remains to be seen.

Here’s what to watch in the stock, credit and currency markets as the week opens:

The stock market: Anticipating that the government would pull out all the stops to halt the credit crisis, the equity market staged a huge relief rally Thursday and another Friday. After crashing to a three-year low Wednesday despite the Federal Reserve’s $85-billion rescue of insurance giant American International Group, the blue-chip Standard & Poor’s 500 index surged 4.3% on Thursday and 4% on Friday to end the week at 1,255.08.

The index’s net change for the week: a 0.3% gain.

What we don’t know is how much the rallies on Thursday and Friday were driven by genuine bargain-hunting investors, as opposed to buying by “short sellers” who were closing out their bets that stocks would fall further.

The shorts -- who borrow stock and sell it, expecting to repay the loaned shares with new shares bought at a lower price -- have become Public Enemy No. 1 at the Securities and Exchange Commission.

The SEC on Wednesday unveiled new rules to curb what it viewed as abusive short selling. The agency followed that on Friday with an outright ban on shorting nearly 800 financial stocks until at least Oct. 2.

The message to short sellers is loud and clear: Back off, particularly from bank and brokerage issues.

Not surprisingly, the stocks that rallied the most Thursday and Friday were financial issues. The financial-sector index within the S&P; 500 rocketed 11.7% on Thursday and 11.1% on Friday.

But short-covering rallies aren’t sustainable. What stocks are going to need this week is buying by investors who really believe that the worst is past in the credit crisis and that the government’s intervention will decrease the chance of a severe recession rather than increase it.

Who wants to go first?

The credit markets: The stock market was a sideshow last week compared with the nightmare in the credit markets. Shell-shocked banks stopped lending to each other and hoarded cash, even as the world’s central banks pumped hundreds of billions of dollars into the banking system.

The situation was worsened by news Tuesday that shareholders of a large money market fund would lose principal because the fund had owned IOUs of failed Lehman Bros. Holdings Inc. That triggered a run on some money market funds as spooked investors pulled their cash.

On Wednesday and Thursday the annualized yield on three-month U.S. T-bills was less than 0.1%, a sign that many banks and other investors had no confidence in any IOUs other than the shortest-term paper issued by the government.

By Friday, after the Treasury unveiled its rescue plan, credit markets began to thaw a bit. The three-month T-bill yield jumped to 0.92% as the frenzy for government debt ebbed somewhat. And interest rates on commercial paper, a critical source of short-term financing for companies, began to ease.

One unexpected element of the government’s rescue package was a program to guarantee money market fund investments, an attempt to keep the $3.3-trillion money fund business from melting down in the face of shareholder redemptions.

This week, we’ll find out whether the federal guarantee worked. If investors keep yanking their cash from the funds, the credit markets could go right back into crisis mode.

The currency markets: The dollar had been the strongman of the world’s major currencies in August and early September. But the buck sank last week amid the turmoil in stock and credit markets, suggesting that some foreigners were retreating from U.S. assets even though financial markets around the planet were in similar disarray.

The euro rallied from $1.42 at the start of the week to nearly $1.45 on Friday.

We need foreign capital, and we’ll need it more than ever to help fund the Treasury’s borrowing to pay for the rescue plan. So a sustained sell-off in the dollar this week could be a dangerous sign: If foreigners believe that the U.S. intervention is a sign of weakness rather than strength, their appetite for U.S. assets could wane sharply.

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tom.petruno@latimes.com