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The word of the week is “deleveraging”. Banks must reduce lending, pay off as much debt as they can and expand their equity base. That has been obvious for many months; what is new is that the time that will be required to return to healthy balance sheets is now recognised as a matter of years (two or three), not months. Deleveraging also applies to households, forced with much reluctance in the USA (UK and elsewhere), to restructure their debts. They cannot borrow so easily because of the credit squeeze and have already backed off buying new cars (and, incidentally, over-priced coffee!). Yet the US consumer is very slow to adjust. A chart produced by UBS shows how, when house price inflation minus 10-year yields turns negative, the savings rate of consumers always turns positive. The first has happened, the second must now follow! |
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Thus there is an understandable reluctance by US politicians to accept that the shift in world economic power, now so firmly underway, means that belt-tightening is inevitable, and, if not undertaken, will be forced upon the USA by the financial markets. When Bernanke and Trichet are hinting at higher interest rates despite the obvious slowdown in their respective economies, what are they really saying? The answer is that inflation due to higher energy and food prices, itself a result of the industrialisation of emerging markets and the growth of a consumer class in these countries, cannot be allowed to wash through to labour costs, as that would exacerbate the problem. Instead, household disposable income must decline. Yes, that implies a lower standard of living! Of course, no politician can say this, neither can central bankers, but they must all realise it (well, perhaps not the White House incumbent, but every one else!). |
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So when commentators ask the question, “How can the central bankers even think of raising rates when the economy is in such a mess?”, the answer is, “Because the alternative is to enter an unstoppable inflationary spiral.” Better suffer somewhat now than massively later. |
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Until recently we thought rises in interest rates this year would herald many successive hikes. We are beginning to change our mind, and rather expect that one or two will suffice. This is because the deleveraging referred to above will itself help bring inflation under a degree of control. Increases in commodity costs cannot massively increase inflation unless, in parallel, money is created to pay the prices. Until recently that money was supplied by both the central banks (the Greenscam policy of which we, and now the BIS, are so critical) and also the commercial/investment banks with their creation of so many securities (CDOs, off-balance sheet, asset-backed commercial paper, junk bonds, etc), all given a false sense of creditworthiness both by the rating agencies and via the hugely growing (and unregulated) market for credit default swaps. All these instruments are now largely out of favour. They are both the cause of deleveraging and its victims. This implies a worsening cycle of write-downs and further deleveraging, needing sufficient time for the whole process to reach a new equilibrium. |
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Deleveraging is not acting fast enough to dampen inflation (see, for example, how slow US consumers are to reduce spending), so an increase in interest rates is needed until the credit squeeze steps in and takes over the “dirty work”. It is not a very happy reason as to why only one or two rate increases will suffice, but it is realistic! Some say that the ECB might well increase rates and then retract when it realises its “mistake”. It might not be a mistake at all, but a deliberate step to hold the fort while waiting for deleveraging to do its worst. |
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While the high prices of oil and food reflect the shortages of both in face of increasing demand, there is a bubble effect as well. Some parts of the bubble are already deflating, but, overall, it is still on the way up. It will probably take a significant decline in the western economies before the bubble finally bursts. |
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Focus |
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(?) Germany: unemployment at 7.2%, the lowest since 1992 |
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(+) Vietnam: GDP expanded at an annual rate of 6.5% in the first quarter |
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(-) Euroland: inflation at a record 4% in June after 3.7% in May, reinforcing the expectation of an ECB rate increase. The inflation rate has even reached 5.1% in Spain and 5.8% in Belgium, a 24-year record |
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(-) Russia: inflation has reached 9% since the beginning of this year versus 5.7% in the first quarter 2007 |
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(-) USA: the plight of consumers is reported to be worse than in 2001. The yield on the 10-year T-Bond has again dropped below 4% |
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(+) Switzerland: a Sarasin analyst reckons an economic slowdown to be imminent and that the SFB will lower rates in the 4th quarter |
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( !) Banks: deleveraging for Fortis includes cancellation of dividend |
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(+) positive for bonds (–) negative for bonds (!) watch out (?) begs the question |
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