Free beer. It’s even better than free money. Beer you can drink right away. Money has to be exchanged.
Your editor is thinking about beer because he’s going to win some of it from Kris Sayce at Money Morning. The Sayceninator was one of several colleagues last week who expressed the view, if we understand them correctly, that the Fed’s decision to raise the discount rate last week was a sign of monetary tightening.
This triggered a flurry of speculation what the net effect would be. Sell equities? Sell bonds? Buy bonds? Sell gold? Buy gold? What what what?!!
Our response: don’t believe the hype.
So we made a bet with Sayce: if the Fed raises the Fed Funds rate at any time in the next three months, or even fixes short term rates at 0.25% instead of today’s free-floating range, we’ll buy him three barley pops. If the Fed Funds rate goes nowhere, that’s more beer for us.
The market seems to agree with us, so far. After an initial fainting spell on Thursday, it remembered itself and gathered its composure. Granted the S&P and Dow didn’t do much on Friday. But they didn’t crash, either. And today Aussie stocks have held their nerve as well and sprinted higher.
The simple, unarguable, world-conquering, completely undeniable, not-to-be-disputed truth is that the Fed cannot raise the Fed Funds rate without doing serious damage to an American real estate market that’s already in intensive care. We would bet a keg of Heineken on it. Why?
A hike in the Fed Funds rate would do more damage to the collateral on the books of America’s banks. It would wipe out more (already thin) capital cushions. And it would undo the work the Fed has done in other markets (securitisation) to get credit flowing. The Fed can’t risk all that.
It’s not the big money-centre banks in Wall Street you have to worry about. It’s the smaller regional and community banks. The Federal Deposit Insurance Corporation shut four more of them over the weekend. That’s 20 for this year, which is a lot less than the 140 last year. But if you wanted to see a spike in U.S. bank failures, you’d definitely raise interest rates.
Besides, why bother? The Euro is in slow-motion imploding as a currency experiment. The dollar, as the not-euro, is getting a bid. At the very least, the dollar bears are closing their shorts for now. The U.S. dollar index is still testing resistance at around 80. As Murray said last week, if it can hold 80, the next stop is 84. That’s consistent with a much weaker euro.
All of this happened without a puny 25 basis point rise in the discount rate. If the Fed really wants to get tight, it can shrink its balance sheet and quite directly supporting lending and asset prices in any number of markets. Until you say a shrinking balance sheet, don’t think Ben Bernanke has suddenly turned in Paul Volcker.
Long-only stock fund managers can sigh a breath of relief then. The easy-money conditions that have led stocks up since March of last year are not disappearing any time soon, as far as we can see. Not that you have an all clear to buy Aussie stocks. But where does that leave us?
It leaves us pretty much in the same position we were to start the month: having no idea what the future holds. We know what SHOULD happen. More global deleveraging ought to lead to lower prices for stocks and real estate and even commodities. We’d expect a bear market in paper money that would have a corresponding bull market in precious metals and precious metals equities.
This is how we resolve having a fundamentally bearish position on the economy but still recommending you own some stocks. Yes, it’s risky. But it is a strategy nonetheless.
Still, we can’t help but think that official policy makers here still underestimate how vulnerable Australia might be to another credit shock. No one is worried about Australia’s sovereign debts because, by comparison, they are a smaller as a percentage of GDP than many other nations. The country’s debt burden is lighter, and thus, easier to service.
But if there is another credit crunch in America due to falling commercial and residential real estate values – how eager are American and European lenders going to be to to lend money to Australian banks? Won’t they want to conserve capital instead? And then where will the money come from?
This leads us back briefly to a few more facts about Australia’s net foreign debt. And here we mean the debt owed by households and corporations too, not just sovereign debt. Based on the maturity schedule of the debt and composition of lender countries, we’d say Australia could have a massive debt shock rather easily.
That would put the Federal government in the position of lender or debt guarantor of last resort. And THAT could quickly lead to rising government debt-to-GDP ratios-exactly the same kind that blew out in America and Europe in the last two years due to similar circumstances. But where’s the proof?
First, have a look at the chart below. It shows that the UK, the US, and Japan make up combined make up 49% of Australia’s foreign debt country. To the extent the banking resources of these countries will be dedicated to saving their own hides in a second credit crisis, you can assume they might not have as much money to lend here. That leaves a huge burden on the remaining lenders, including the 32% classified as unallocated (whoever that is).
But the problem is more serious when you read about the maturity schedule of Australia’s foreign debt. According to 2008 data, over $400.1 billion dollars of Aussie foreign debt – or 35.4% of the total – matures in 90-days or less. Nearly half the debt total – $514 billion – matures in one year or less. What does that mean?
We think it means two things. First, that’s a lot of debt to roll over in a short period of time. It gets even harder to do when your lenders have bigger fish to fry. Second, it makes your borrowing a lot more interest rate sensitive. You may indeed be able to borrow. But it will cost you a lot more to do so. And you can be sure that if the Big Four Aussie banks have to pay higher rates internationally, they’re going to pass on those rates domestically. We’ll see what happens to housing finance commitments then.
One guess is that the government will have to pony up more money in the residential mortgage backed securities market (RMBS). The government has pumped more than $8 billion into the market since 2008, according to Danny John in today’s Age. This means the housing boom is being propped up by government borrowing to support lending.
There are more than few outrageous aspects to all of this. For one, it looks to use like many of the non-traditional lenders who are financed via the AOFM are loosely affiliated with Big banks anyway. It’s a way for the Big Banks to practice high-risk lending and sell the loans to the AOFM, all in the name of making housing “affordable” to people whom the Big Banks won’t lend to on their own balance sheet. That’s pretty shady.
The issue for Australia is whether the back-door rigging of Aussie house prices by the AOFM will eventually endangers Australia’s ability to pay its sovereign debts. Granted, $8 billion here or there hardly seems like the sort of thing to break the national bank these days. But it’s the trend that concerns us.
That trend is that in markets where traditional financiers and lenders won’t participate, the government is forced to come in and put the public balance sheet on the line. There are few markets more politically important than housing. You can see why the government is committed to supporting prices even if it means supporting friendly affiliated non-bank lenders with billions in the securitisation market when few others will.
But our question this week is what happens to that $500 billion in foreign debt with a maturity date of less than one year? What happens in another credit crunch if Australia’s main borrowers – and let’s be clear it’s the big banks and financial companies we’re speaking off – have to pay more to borrow (assuming they can get it?)
One obvious answer is that the federal government will have to step in. This could lead to transfer of private liabilities on to the public balance sheet here in Australia in just the same fashion it happened in the U.K. and the U.S. And for a nation already carrying a large foreign debt burden, it might not take much for such a crisis to put the federal finances on incredibly unsteady ground.
But maybe we’re just grumpy because it’s Monday.
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