Aug 10 2007
The Central Banks spook the markets
Yesterday, share markets around the world were in free fall.
That came hard on the heels of the Bank of England forecasting a further rise in UK interest rates, and saying people owning high risk debt had to accept it was overvalued. They should expect no bail out.
It followed the Fed keeping rates on hold and telling holders of risky debt to??accept??their losses. The Fed too denied any wish to ride to the aid of institutions that had made bad loans.
It was??taking place as??the European Central bank pumped more than ??60 billion of money into the banking system when it became alarmed that the dodgy debt crisis had spread to European banks.
Some market participants were more spooked by the actions of the ECB, who drew attention to the serious nature of the European banks’ involvement with sub prime and other risky debt by easing to accommodate it. Others will be more spooked by the reluctance of??the Fed to cut interest rates to ease the crisis, and by the Bank of England’s approach of wanting to inflict more pain on borrowers to be sure they have squeezed inflation out, having lost control of??price rises??against target sometime ago.??Still others??want to go on squeezing inflation but don’t want to accept this means lower share prices as well as falling bond prices.
The market falls should come as no surprise to readers of this blog.
On July 5th I wrote:
"So far the general view is that the sub prime mortgage market will continue to be in distress, but these problems will not spread. However, a similar pyramid of debt has built up around company borrowing?? around the world. If the Fed, the ECB and the Bank of England keep raising interest rates there could come a tipping point where there was a sharp fall in corporate debt markets just like the sub prime collapse"
On 14th July I reminded readers of the overextended??state of western financial structures:
"This buying (of the dollar by Asian countries) has enabled the US and other western countries to carry on borrowing, building the credit house of cards which characterises the modern western economy"
On 25th July: "There are billions of dollars in all sorts of fancy and clever arrangements and funds which will need to fall in value if the squeeze goes on"
On 26th July: "If they (the central banks) don’t back off soon it could be quite a collapse"
The Central Banks call the shots. All of the decline so far has been caused by the decision to raise rates susbstantially in the US, the UK and Euroland, and to effectively force the banks to tighten their lending criteria. Both the Fed and the Bank of England has been saying there will be no premature easing or bail out. The ECB has been saying it will carry on tightening, looking at the relative success of the German economy and its inflation fears. Suddenly yesterday it??worried about ??the state of some banks and funds. Presumably??it had realised before that European banks and funds have bought many of the highly borrowed instruments coming out of the US that are now caught up in the so called sub prime and wider debt problem, but chose yesterday to highlight it.
??Why??can the damage spread from bonds, from borrowings, to shares? For??several reasons:
The first is that banks and funds needing money will often find it easier to sell shares where they have good profits, to help them tackle the losses and cash shortage they have got into by dealing in debt instruments that have fallen. They often have to put more money up because the underlying "asset" has fallen in price and that requires them to pay more "margin" when they are dealing in certain types of financial instrument based on that underlying asset.
The second is that the losses??from holding dodgy debt will in part be made by financial service companies, investment funds and banks that are quoted on the stock market. You would expect their share prices to fall - if all other things are equal - to reflect those losses.
The third is that if the Central banks carry on with the squeeze it will hit people’s ability and willingness to spend.
The fourth is that as bonds start to offer a better income, people will expect shares to do the same, which means some combination of lower share prices and/or higher dividend increases.
What is clear is that different approaches by the main three western central banks is not helping create stability. Yestersay’s big falls occurred when the ECB took a different approach from the Bank of England and Fed.
Every word and every action from the Central banks now matters greatly. They have to decide when they have squeezed and rattled the markets enough.
John Redwood has been the Member of Parliament for Wokingham since 1987. First attending Kent College, Canterbury, he graduated from Magdalen College...
Isn’t all this good for hedge funds that saw this squeeze coming though? You say that this should come as no surprise to readers of your blog, it doesn’t, and if I was filthy rich I’d have stashed all my cash away in hedge funds with what I considered to be sensible positions as soon as you (and others) alerted me to the impending squeeze.
As you said the other day ‘prices work’. Financial whizz-kids have been warning everyone about these credit derivatives for long enough, I’m surprised so many people are being caught out. If Warren Buffett offered me some financial advice I’d listen to him.
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Didn’t Warren Bufett call these credit derivatives ‘weapons of financial mass destruction’ in 2003?
I know you’re not the biggest fan of the BBC’s output, nor am I at times, but http://news.bbc.co.uk/1/hi/business/2817995.stm
You see, I would have taken heed of that warning, just like I think ‘Hmm, this John Redwood is a clever and knowledgable guy, I wonder what he has to say, maybe I can learn something.’
But banks will not care about this as long as they get bailed out by the ECB surely?
Reply: Banks that have lent too much money to people who can’t afford the mortgage or to funds that have bought mountains of dodgy debt have no easy way out of the problem - they are all trying to sell on their dodgy debts to each other. They are hoping for a bail out.
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Hedge funds like many modern investment vehicles are a bit, how shall we say, iffy.
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Interesting article which explained the situation to those of us who do not have a degree in economics while still having to balance the personal finances.
Sometimes in the greater scheme of things, the dynamics which effect the world markets or the UK economy get a headline on the 6pm or 10pm news bulletins, but fail to make an impact on ordinary voters because the story never goes into the level of detail which explains how it will eventually impact on them.
One thing that worries me most about political parties is way that none of you are prepared to get too honest with us about the unacceptable level of personal debt in the country. What does the platitude “its manageable” mean? For a lot of people they think it means that they are safe to carry on as they are because there is a safety net all ready on standby to catch them with a soft bounce.
How about a bit more honesty about the level of uncertainty about the credit boom? Would it be so damaging if we issued a more stark warning that we need to reign in the spending, pay off debts like credit cards or loans to protect the more important debt like mortgages? I know, it does not send a positive message and might negatively impact on the economy, but by allowing the economy to carry on with this almost decadent access to debt risks a 10 year boom turning into Armageddon rather than a bust.
Glad I bothered to see this coming and took the appropriate measures, others won’t but will still feel like the victim and look for a culprit to blame.
Reply: Opposition parties have held debates on how there is too much debt in the economy, pointing out that at some point higher interest rates and a weaker economy will leave too many people struggling to pay the interest let alone repay the principal. If the Bank of England decides to really squeeze inflation out of the system it will mean more personal and corporate bankruptcies.
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In 1979 much of what is now Labour heartland was blue. Twenty-odd years ago folk up my end of the country were marching on London in protest at pit closures. I blame all this easy money and consumerism partly for the political apathy that has swept the nation.
Hardly anyone actually cares about anything these days. Up my way they all blindly vote Labour bacause their parents did or because they read the Daily Mirror. A recession on Gordon Brown’s watch might change a few things politically - which is why he’ll just borrow even more money and pump it into pointless projects to keep alive the illusion of prudence and prosperity.
Worldwide tightening of monetary policy? Don’t worry, Father Brown won’t let the world economy affect you, get back to your reality TV and credit card funded shopping sprees. Turn on the Brown Broadcasting Commissars and watch some more house-porn. Everything will be alright while Father Brown is looking after you.
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