Not one but three different banks are warning investors of major crisis ahead. Note to the banks: where have you been for the last year? A thousand martini lunch?
The slow-motion credit crisis is nearly twelve months old. The question today is whether the competing interest rate policies of the European Central Bank and the U.S. Federal Reserve will lead to more selling in global stock markets and higher commodity prices. Inflation is winning the war.
“A very nasty period is soon to be upon us – be prepared,” says Royal Bank of Scotland’s chief credit strategist Bob Junjuah. In Wednesday’s U.K. Telegraph Junjuah says, “The Fed is in panic mode… The massive credibility chasms down which the Fed and maybe even the European Central Bank will plummet when they fail to hike rates in the face of higher inflation will combine to give us a big sell-off in risky assets.”
Aussie stocks are caught in the thematic cross fire. Higher commodity prices are good for commodity producers. But global inflation sows the seeds of global recession, which is not bullish for resources.
Morgan Stanley’s European research team says an European Central Bank rate hike next month (the one Jean Claude Trichet has threatened to deliver) could lead to a “catastrophic event.” Morgan’s report concluded that, “We see striking similarities between the transatlantic tensions that built up in the early 1990s and those that are accumulating again today. The outcome of the 1992 deadlock was a major currency crisis and a recession in Europe.”
Hang on. If the U.S. dollar stays weak and the euro falters, where does that leave us? Well, you might see more strength in higher-yielding “commodity currencies” like the Aussie and New Zealand dollars. Not Canada though, as the Canadian economy will suffer from a U.S. recession. But the real eye opener of simultaneous dollar and euro weakness is what it says about paper currencies.
Investor’s don’t believe that the central bank is really in control anymore. They are losing confidence in the main product of central banks, paper money. Precious metals and energy are the nearest, liquid investment alternative to paper currency weakness.
Even the Bank for International Settlements-sometimes referred to as the central banker’s central bank-says the danger from the bursting of the credit bubble is not over and could get much worse. The only people that think this is news are the people who thought you could have a bear market in credit and rising stock prices. That is utter balderdash.
Let’s take a quick look at BIS working paper number 137, “The Great Depression as a Credit Boom Gone Wrong“, published in 2003 by BIS author’s Barry Eichengreen and Kris Mitchener. In that delightful read (published right before the U.S. housing boom went parabolic) the Bank tells us how credit bubbles lead to real busts.
“A capsule account of the role of credit in macroeconomic cycles, as informed by the experience of the 1990s, would go something like this. There is first an upswing in economic activity. As the economy expands, banks and financial markets provide an expanding volume of credit to finance the growth of both consumption and investment, particularly where regulation is lax and competition among bank and nonbank financial intermediaries is intense.”
“Whether because the exchange rate is pegged or for other reasons such as a positive supply shock, upward pressure on wholesale and retail prices is subdued. Hence, the central bank has no obvious reason to tighten and stem the growth of money and credit, leading to a further expansion of output and further increase in credit.”
“Higher property and securities prices encourage investment activity, especially in interest-sensitive activities like construction. But, as lending expands, increasingly risky investments are underwritten. The demand for risky investments rises with the supply, since, in the prevailing environment of stable prices, nominal interest rates and therefore yields on safe assets are low.
“In search of yield, investors dabble increasingly in risky investments. Their appetite for risk is stronger still to the extent that these trends coincide with the development of new technologies, in particular network technologies of promising but uncertain commercial potential.”
“Eventually, all this construction and investment activity, together with the wealth effect on consumption, produces signs of inflationary pressure, causing the central bank to tighten. The financial bubble is pricked and, as asset prices decline, the economy is left with an overhang of ill-designed, non-viable investment projects, distressed banks, and heavily indebted households and firms, aggravating the subsequent downturn.”
Everything in that description of the credit cycle matches this latest boom/bust, except the last part. Inflationary pressures in the world economy have two sources: rising resource consumption from emerging markets and loose monetary policy in the major developed economies. Demand and money supply are both growing.
The obvious effect is rising prices. But the central bank has not reacted to higher rates of inflation by raising rates…because if they do that…at least in the States…it will absolute wreck household balance sheets already heavily leveraged.
And so here we are. Three crash warnings-all of them one year too late. Here’s a thought: The destruction of wealth will continue but the world will not end.
The biggest credit bubble in history takes years to deflate. It was naive to think the market could price it all in a few months. That would have been impossible, if only because we still don’t know the full economic effect of falling asset prices and the billions of securities still tied to the value of U.S. homes.
You can’t properly price what you don’t know. The best strategy in that case is to stay as far away from financial stocks as humanly possible.
Markets and Money