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Fellow members of the G7 are resisting the USA’s request to stimulate their economies along the lines of its own tax and interest rate cuts. This may reflect two views of the USA emerging among the authorities of the “Rest of the World”: |
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- “This mess is of your creation. Don’t ask us to follow you down the path of still more irresponsibility”
- “It is high time to correct the world’s economic imbalances. You’ve got to consume less and sell more. If that means recession for you, too bad. It may even mean recession for some of us, too, but we’ll live with that if better balance is the prize
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There is a growing perception on both sides of the Atlantic that interest rate cuts will not “do the trick” this time, and that fiscal stimulus, should it work, cannot solve the long-term weakness of an economy dependent on indefinite deficit financing. If that is the view of the authorities, then that of the markets represents the other side of the same coin: trust in US paper, especially of anything linked to the whole securitisation process, has evaporated. Lower interest rates may enhance the demand for loans, but they do not do much for their supply. The impact of the declared and undeclared CDO losses of banks has already reduced their capacity and willingness to lend. Lower interest rates can but reduce that willingness further, despite the yield curve steepening mentioned in “Focus”, below. |
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We have often written of systems failure. A key dimension of that failure has been absence of transparency in parts of the fixed-interest market. This has taken two forms: |
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- For asset-backed bonds, cleavage between the public face of the security and the assets behind it. This is inherent in the securitisation process and made worse by the use of off-balance-sheet “Special Investment Vehicles”
- For structured products, so much complexity that neither the investors nor the issuing banks’ senior management can come to grips with the true risk/reward implications (witness SocGen)
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The current crisis is encouraging a return to transparency, or to express the trend differently: the movement to greater transparency in corporate reporting and in stock markets is now spreading to the murkier parts of the fixed-income market. Consider the infamous “SIVs”: were they not the key to Enron deceiving investors as to the true financial performance of the company? They were effectively banned in the wake of the Enron crisis and of the hastily written Sarbanes-Oxley Act (“SOX’). How is it that SIVs could still be used by banks to hide their misdeeds? Our own philosophy and practice has, by the way, always been to focus our and our clients’ attention on the fully transparent parts of the fixed-income market. Clear evidence of the “back-to-basics” trend is apparent in the ease with which solid industrial corporations are issuing new bonds, while providing proper financial data on the company and on the planned use of new capital. This is not at all unexpected; if investors no longer trust CDOs, and are moving to quality, there remain only the government and quality corporate sectors. What a pity there are so few new issues of quality corporate bonds. |
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In the meantime, the huge menace of monoline downgrading is growing, while rescue efforts are advancing only very slowly. We find it unimaginable that the US authorities let the downgrading go ahead. The disaster in terms of forced selling of corporate and municipal bonds, which would also be downgraded, would threaten the financial system beyond anything yet seen. While the authorities are trying to reflate consumer spending by lower rates and tax rebates, the real threat is to and within the entire credit system. |
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Beyond the current crisis, there lies the need for greater transparency of banks and of the opaque parts of the fixed-income market. It would be nice if market forces could bring about the improvement alone – nice but unlikely. Tighter regulation is inevitable. We only hope that it is developed in a calmer atmosphere and by more expert legislators than for “SOX”. |
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Focus |
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(–) South Africa: ZAR has fallen sharply this year -7% against USD and 9% against EUR |
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(–) Australia: inflationary pressures have pushed the RBA to raise its interest rate by 25 bps to 7%, the highest level since 1976 |
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(–) New Zealand: NZD has risen 6% against USD in two weeks. The RBNZ is expected to maintain its interest rate at the current 8¼% for several months |
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(!) USA : the steepening of the swap curve after 3 years is remarkable. 10 over 2 years spread on Jan1 was 87 bp – now 140. For the first time time since 2003 employment declined (-7,000). Futures markets imply a 98% probability of a 50 bp Fed cut next meeting, vs. 68% Monday. Lower tax revenues and Iraq are leading to a USD 400 billion deficit 2008 and 2009 (2.9% of GDP) |
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(?) Euro zone: in 2007 producer prices rose 4.3%, confirming the inflationary impact of food and energy prices |
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(+) positive for bonds (–) negative for bonds (!) watch out (?) begs a question |
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