Thursday, 4 August 2011

Credit Crunch 2?

Almost exactly three years ago, I wrote a blog warning that there was a catastrophic financial collapse literally imminent - Severe Financial Warning. I said it would be a crisis of Biblical proportions, and indeed when a couple of weeks or so later, it did break, it was the worst Financial Crisis that Capitalism has ever experienced.
In that blog, I pointed out that the reason I believed that such a severe crisis was about to break was that in the markets over the previous couple of days, there had been a dramatic fall in the price of oil that seemed to have been caused by Financial Institutions selling those investments – like Oil – which had risen strongly in the previous period. They were doing so not because they wanted to, but because they had to, like someone getting their house repossessed. They had to, because they needed cash, and as interbank lending stopped completely, selling these other investments was the only way to get it. Developments today with the DOW off by more than 500 points at the close suggest something worse might be on the way.

In the last few weeks, conditions in the credit markets have been tightening sharply once again. Everyone knows that the Bank Stress tests, carried out a few weeks ago, across Europe, were a sham. They failed to take into account what would happen to Banks, for example, should a sovereign debt such as Greece, Ireland, Portugal, Spain or Italy default. They did, however, contain details of just how much the Banks were exposed to such risk, and that data will have been poured over by the analysts within the Financial Community in the last week or so.
In addition, as I wrote recently the European deal over Greece was a fudge. The consequence has been that once the diversion over raising the US debt ceiling was cleared out of the way, the focus would return to the real problem, which is the large amount of European sovereign debt within the peripheral economies, and the fact that the austerity measures being adopted are cratering growth across Europe, including the UK, and are thereby undermining the only credible means of these economies escaping from their debt problems. Even in the UK, the effects of austerity, which have not really begun to be felt yet, have effectively sent the economy back into negative growth, with the consequence that the Government is seeing the deficit rise rather than fall, as tax revenues fall, and welfare benefit payments rise.

The ground seems to be being prepared to change policy. Cameron has let it be known that he is worried about his Chancellor's current policies, and is looking for an alternative to restore growth; the IMF has said that the economy is heading in the wrong direction, and that, if it continues, the Government should look to changing course, introducing tax cuts etc.; the Government's own Office For Budget Responsibility has even come out to warn about the condition of the economy; Vince Cable has called for more money printing, and the Federation of Small Businesses has called for VAT to be cut to just 5% on the construction industry, and Tourism. Similar rumblings are being heard in other European countries.

The yields on the Italian and Spanish 10 year Bonds have now gone well over 6%, a figure, which means that their debt is becoming unsustainable. At these levels other PIG economies had to be bailed out. A number of Italian Banks are known to have a considerable amount of Italian Government debt on their books.
This morning trading in one of the largest Italian Banks was suspended for a while as its share price had fallen by the daily limit. Talks are going on about bringing in changes to the EFSF and EFSM support mechanisms used for bailing out Euro economies, but little has been done, and European politicians have now gone on holiday! Both these mechanisms are insufficient to bail-out economies of the size of Spain and Italy. Only the selling of EU Bonds would hold out the prospect of doing that, and for now wrangling between the leaders of different EU states is preventing that from happening. It will require a closer union with some form of Fiscal and Political Union. Ironically, the Eurosceptic Tories have said they would not stand in the way of the Eurozone doing that!

Most market participants were looking for markets to stabilise or rise today following yesterday's recovery. But, growing concern over the Euro debt crisis, followed by the news conference given by the ECB after deciding to keep rates on hold set off an avalanche of selling that intensified towards the US close of trading. But, what could be more concerning was what happened to the price of Gold, and to Bond prices. For the last few weeks, as risk aversion has grown, money has been flowing steadily out of Equity Markets and into the Bond Markets of what are considered to be safe havens, as well as into Gold.
Earlier today, Gold hit a new all-time in Dollar, Euro and yen terms. It stood at over $1680 an ounce. By the close it had fallen $30 an ounce to stand at $1650, though as the dollar rose, Gold was still higher on the day in sterling and Euro terms. The movement of money from equities into Bonds, is what has driven interest rates to record lows.

The Tories crow that UK interest rates are low due to their fiscal austerity measures. That is nonsense. After last year's austerity Budget, Yields on the UK 10 Year Gilt rose from being at 3.2% earlier in the year, to over 3.8% later in 2010. Despite the fact that the Tories are failing to reduce the deficit, the Yield has now fallen to just 2.6%. That is the lowest interest rate since WWII! But, in the US, with its huge debt, interest rates are even lower at 2.5%. Japan, which has an even larger debt has a yield on its 10 Year JGB of only just over 1%!!! The reason for these low rates is nothing to do with austerity or controlling debt, it has everything to do with the fact that global investors know that none of these economies are going to default on their debt, and needing to put their vast sums of money somewhere they are parking it in these Bonds.

Yet, as this massive sell-off in shares took place, not only did Gold fall, but there was no sign that any vast new sums had gone into Bonds. That could be as one market commentator said, because in such a risk averse atmosphere the money simply went into cash. But, it could also be that once again, as in 2008, we are seeing distressed Financial Institutions scrambling for liquidity. The stampede out of equities is undoubtedly motivated by fear that the austerity measures now being proposed for the US will have the same devastating effect on growth that they are having in Europe, and the consequent disastrous effect that will have on profits, and the destruction of Capital. But, then you would expect that money to go into Gold, Bonds and other similar assets. Gold did move up and down during the day suggesting a battle was going on between buyers and sellers.

It suggests to me that we could be seeing Financial Institutions selling Gold and other assets, once again not because they want to, but because they have to. If the credit markets are once again freezing up because of fear over counter party risk, as Banks throughout the globe risk seeing their loans go bad, that is precisely what you would expect to see happen. This morning, it was not just Italian banks that were being hit, British Banks saw their shares falling by 6,7 and 8%.
Moreover, a number of reporters at the ECB press conference, such as CNBC's Sylvia Wadwha said that they were being told that the ECB has been buying Irish and Portuguese Bonds in the secondary markets, but not Italian Bonds. According to Italian Finance Minister Tremonti, the Asians have said to him, if the ECB will not buy Italian Bonds, why should they!

I suspect that in the coming days Gold will rise again, because anyone who does not need to sell it in order to raise cash will have every reason to buy it. Moreover, Trichet did say that the ECB would be engaging in what amounts to a form of money printing over the next six months. If the credit markets even remain tight, and support is required for Italy, Spain and other countries – even France's 10 Year OAT, rose today to around 4% - then with the EU politicians away on holiday, the only mechanism for intervention will be by the ECB stepping in to provide liquidity. At a time when global commodity prices continue to rise as the booming economies of the East continue to suck in large amounts for their growing production, such money printing can only result in higher inflation.

There comes a point beyond which even those buying Bonds today will begin to get cold feet, as they get little interest on their holdings, whilst their value in real terms continues to fall with inflation. In those conditions, the role of Gold as real money, and store of value reasserts itself. That is why many Central Banks have again become buyers of Gold.

For an economy like the UK that could quickly have a devastating effect. Its low interest rates are essentially built upon that influx of “hot money”. That has allowed Banks and Building Societies to keep mortgage rates down to unsustainably low levels. Without that increasingly stretched family budgets would have gone beyond breaking point. As the ITV's Tonight programme showed, there are already a large number of people in arrears on their mortgages, and repossessions have remained relatively low due to Banks exercising “forbearance”.
Even a 1% point rise in mortgage rates will send the housing market into a tailspin. The consequence will be that the huge mountain of private debt – which at around £2 trillion is more than double the Public Sector debt – will come down in an avalanche that will bankrupt most of the Banks and other financial institutions who have lent irresponsibly against those mortgages in the last 20-30 years, as well as all those other institutions that have insured that debt, or bought into it by various SPV's such as mortgage backed securities.

Credit Crunch 2 could be much worse than that of 2008, because it has now passed to the default of sovereign debt, because it now threatens to see the defaulting of the vast amount of private debt held in credit card, and other debt, and because a considerable amount of ammunition was used up in stopping the original Financial meltdown in its tracks.
But, possibly more importantly there is a political difference. In 2008, even Bush was prepared to introduce whatever Keynesian measures were needed to bring the crisis to a halt, and the US following the lead given by Gordon Brown, was able to get other G20 countries to follow suit. Today, the Tea Party has been able to pressure the republicans into adopting austerity. EU politicians remain tied to a similar path, and today Ozzy Osbourne is in charge of the British finances. Whatever you said about Brown, you would have to say that given the choice you'd have more confidence that he might do the right thing under these conditions.

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