The Federal Reserve said today that will create a Commercial Paper Funding Facility (CPFF) to help provide liquidity to term funding markets. The Treasury believes this facility is necessary to prevent substantial disruptions to the financial markets and the economy. Initially, the stock market and high yielding currencies reacted positively to the news but then gave back most of their gains once investors decided to take profits ahead of Ben Bernanke speech on the economic outlook and financial markets before the National Association for Business Economics.

Despite the Good News The U.S. Economy Faces Substantial Challenges Ahead

Investors expect that the recent efforts by the U.S. Federal Reserve to clean the market from some toxic assets could lead to a more general recover in the appetite for risky assets like high yielding currencies. However, the U.S. economy is likely to continue to face substantial challenges including further job losses, high energy prices and a rapid deleveraging in the financial sector. Moreover, some investors are concerned with the fiscal impact of the bailout plan which could cost almost 5 percent of GDP. Currently, the United States federal government runs a deficit of $438bn, or 3 per cent of gross domestic product and the bailout costs could push the fiscal deficit next year to $1 trillion or 7% of GDP.

Federal Reserve Press Release

"The Federal Reserve Board on Tuesday announced the creation of the Commercial Paper Funding Facility (CPFF), a facility that will complement the Federal Reserve's existing credit facilities to help provide liquidity to term funding markets. The CPFF will provide a liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle (SPV) that will purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers. The Federal Reserve will provide financing to the SPV under the CPFF and will be secured by all of the assets of the SPV and, in the case of commercial paper that is not asset-backed commercial paper, by the retention of up-front fees paid by the issuers or by other forms of security acceptable to the Federal Reserve in consultation with market participants. The Treasury believes this facility is necessary to prevent substantial disruptions to the financial markets and the economy and will make a special deposit at the Federal Reserve Bank of New York in support of this facility.

The commercial paper market has been under considerable strain in recent weeks as money market mutual funds and other investors, themselves often facing liquidity pressures, have become increasingly reluctant to purchase commercial paper, especially at longer-dated maturities. As a result, the volume of outstanding commercial paper has shrunk, interest rates on longer-term commercial paper have increased significantly, and an increasingly high percentage of outstanding paper must now be refinanced each day. A large share of outstanding commercial paper is issued or sponsored by financial intermediaries, and their difficulties placing commercial paper have made it more difficult for those intermediaries to play their vital role in meeting the credit needs of businesses and households.

By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations, this facility should encourage investors to once again engage in term lending in the commercial paper market. Added investor demand should lower commercial paper rates from their current elevated levels and foster issuance of longer-term commercial paper. An improved commercial paper market will enhance the ability of financial intermediaries to accommodate the credit needs of businesses and households."

Antonio Sousa is a Currency Analyst for FXCM.