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Over the years, we can claim to have “called” many economic developments correctly, such as the secular decline of the USD and the “L-shape” of the recession and associated weak recovery. We have, however, made one major error in that we expected the end of quantitative easing to lead to yield curve steepening. The logic seemed irrefutable: the US government would have to compete for its borrowing with the private sector, and accordingly, would have to pay higher longer-term rates. This has not happened, although a kind of “shadow” has occurred in bank lending, in that banks are opting to lend to the Fed rather than to businesses or homeowners. |
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While the political leaders in the USA and the euro zone are dithering, the Fed, at least, is committed not only to indefinitely low short-term interest rates, but also to low long-term rates. Quantitative easing has already achieved this, and it seems that, even if no new funds are committed by the Fed to buying Treasuries, the average maturity of its T-Bond holdings will be lengthened, i.e. the Fed will flatten further the yield curve. The policy has powerful arguments in its favour: |
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- lower long-term rates reduce mortgage costs and thereby help the housing market
- industry can borrow cheaply and will therefore invest more
- the interest cost of Government debt is reduced
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There are however two major counter-arguments. The first is simply that low-interest loans for already cash-rich corporations are not prompting investment because the economy is so weak. Other than for refinancing purposes, this makes further borrowing unattractive. |
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The second counter-argument is that the whole basis of commercial banking operations is being undermined. Banks take deposits and borrow cheaply at short-term rates, whilst lending longer-term at higher interest rates. Remove or drastically reduce the spread between short-term and longer-term rates and the model simply no longer works. Then, if that were not enough of a problem, Basel III is imposing greater reserve requirements even if these requirements are less draconian that first proposed. In addition, the US Government is suing them over the sub-prime fiasco, and there are many other civil suits about selling toxic securities. Many European banks are also exposed to downgraded sovereign debt. It is therefore not surprising that financial markets are losing confidence in banks, and the banks are subsequently losing confidence in each other. |
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Whilst many might have little sympathy for banks, they do fulfil an irreplaceable role in the economy. The 2008 crisis was understandably focused on banks, however the 2011 crisis has broader implications: in the USA, for unemployment, housing and Federal indebtedness, and in Europe, about sovereign debt and whether austerity programmes will induce recession. Have the long-term problems of the banking crisis been overlooked? We would suggest that it is another cause of a long period of slow or negligible economic growth in the West, which began in 2008. |
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Bravo to the Swiss National Bank for stopping the rise of the CHF. It will now be seen which currencies, as well as gold, will be the beneficiaries of the flight from both EUR and USD. It will also be interesting to see the implications for Swiss inflation, given the effect of the SNB’s last intervention in the DEM/CHF rate thirty years ago. |
Market Focus |
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- USA: employment data remained unchanged at 9.10%. However, business activity surprised on the upside expanding at a faster pace than expected in August. The US Federal Housing Agency filed lawsuits against 17 banks in a bid to recoup up to $196 bln spent on mortgage backed securities by Freddie Man & Fannie Mae
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- Europe: overnight deposits from financial institutions with the ECB rose to their highest level in over a year, reflecting continued unease in interbank lending. CDS contracts on European Sovereign and Financial debt surged to new record levels. Investor confidence dropped to the lowest level in over 2 years and manufacturing contracted more than initially forecast in August. The shadow council of the ECB has recommended a reversal of this year’s rate rise
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- Germany: factory orders fell 2.8% from June. Data on GDP showed that the Q2 slowdown was caused by declining household spending and a rise in imports. Retail sales held steady in July after a strong move higher in June
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- Greece: budget deficit targets will be missed in 2011 as the country’s recession deepens. The economy is now expected to shrink 5% in 2011, making deficit reduction to 7.5% of GDP much less likely. CDS contracts are pricing an 87% chance of default within 5 years
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- UK: retail sales fell in August and were 0.60% lower from a year earlier. The Purchasing Managers Index for services dropped from 55.4 to 51.1, and manufacturing shrank the most in two years. An index of consumer confidence dropped sharply. Attacks on the proposed separation of retail and investment banking are growing with an Ernst & Young report suggesting that loan rates could rise as much as 1.5% owing to an increase in wholesale funding costs for Investment banking
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- Switzerland: GDP rose 0.4% in Q2 after a 0.6% rise in Q1. Manufacturing slowed to the weakest level in two years, with the PMI falling from 53.50 to 51.70. The SNB responded to the acute threat to the Swiss economy by setting a ceiling against the EUR of 1.20. The SNB were successful in pegging the CHF to the DEM from 1978 to the late 1990s, although the policy resulted in a number of above-target inflationary periods
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