We Are Where We Are

Sir, Before my fixed-term bond with London Scottish matured on November 21, I was invited to reinvest the proceeds for another year at 7.15%; an amazing and tempting offer in today’s markets.

On due reflection I decided that, as with previous rates offered by Icelandic banks, it was “too good to be true” and did not proceed. How wrong I was. I understand that this investment, however large, will be honoured by the government.

The moral must be to find the shakiest bank and invest in its most ridiculously high fixed-rate bond. No judgment or personal responsibility required, the taxpayer will take the strain.” - Letter to the Editor, Financial Times, December 4, 2008.

• • •

I see soup canteens, dole queues too / I see the boom all over for you / And I think to myself what a wonderful world.

I see flats unsold, old bomb sites, / Property investors receiving their last rites / And I think to myself what a wonderful world.

The colours of a mushroom cloud so ghastly in the sky / Are also on the faces of people going by / I see friends shake Guy Hands saying: what did you do?. They’re really saying: We will sue.

I hear babies cry, I watch them grow / They’ll owe much more than I’ll ever owe / And I think to myself what a wonderful world.

(with apologies to Bob Thiele, George David Weiss and Louis Armstrong.)

• • •

So there we have it. Whether it was the rest of us, or just the news media, we have ended up talking ourselves into recession. Indeed the US National Bureau of Economic Research announced last week that economic activity peaked – and that recession therefore began in the US – as early as December last year. Their ‘Business Cycle Dating Committee’ reports that it views “the payroll employment measure, which is based on a large survey of employers, as the most reliable comprehensive estimate of employment. This series reached a peak in December 2007 and has declined every month since then.”

And Richard Lambert, director general of the CBI and former editor of the Financial Times, went on to suggest that journalists had spread unsubstantiated rumours about troubled financial institutions and that the Press Complaints Commission should have issued guidance to business journalists on the importance of accurate information amid a crisis. But,

Instead, there had been stories that had alarmed savers with melodramatic language, unsourced quotes and suggestions that problems in one institution were spreading to others.

Perhaps the likes of Robert Peston should always be allowed to salivate energetically, and in his case oscillate vocally, over the failure of the latest financial institution – even when briefed selectively by unpublished, price-sensitive sources whose first responsibility should be to the Stock Exchange. But nobody could accuse the (financial) media of even-handed coverage of the financial crisis, nor of the recession / depression that now follows in its wake.

But we are where we are. Now that UK base rates are back down to levels last seen during the Festival of Britain, it is becoming increasingly difficult to shelter in cash, as the government’s War on Savers moves into full throttle. Gilt yields, similarly, are starting to look eye-wateringly slender; but they could easily become even flimsier. As James Ferguson, Chief Strategist at Pali International, has observed:

..all things are not equal.. the experience of systemic banking crises and their attendant recessions suggest that bond demand, from both non-bank investors but especially from the banks, could explode beyond anything seen for decades, completely swamping new supply. Meanwhile, the banks’ de-risking of assets will pump powerful deflationary pressures into the real economy.

The idea that banks could comfortably absorb the colossal supply of “new” Gilts is, at first sight, somewhat counter-intuitive – but James makes a convincing case for Gilt bulls. Increased demand for UK government debt will likely come from two specific areas:

First, a normal rebalancing of portfolio preferences in favour of a heavier weighting in government bonds, as is quite usual in recessions and at other times of increased investor liquidity preference.

Second, and less obvious, it is a feature of systemic banking crises that banks, once recapitalised by state funds and whilst working to shrink their risk assets, concentrate their efforts particularly on de-risking the profile of their remaining assets.

It is certainly becoming acutely obvious that banks remain unwilling to lend, both to individuals and to corporations. Instead, they may simply elect to park capital in the Gilt market and earn the essentially riskless spread of longer dated Gilt yields over shorter ones. And as James points out, the potential for banks to absorb Gilt supply is startling:

..a big bank like, say, RBS could potentially soak up this massive excess supply all on its own. RBS has £1.95trn in total assets, of which £728bn is loans.. If we take a muted version of the Indonesian [banking crisis] scenario, within five years it’s possible that loans could shrink 20% to £585bn (30% of assets) whilst if Gilt holdings increased to just 15% of total assets (they reached 45% in Indonesia), that would imply demand of £300bn, just from RBS alone: enough to soak up our assumed five-year excess supply of Gilts in its entirety.

Basing an investment thesis on presumptions, albeit well-founded ones, of future buying by third parties is obviously somewhat fraught. Investors seeking quasi-cash alternatives and considering Gilts can comfort themselves that in Japan, a major economy that underwent a property and banking crisis throughout the 1990s, government bond yields fell further than the wildest expectations of the most expectant bulls: 10 year Japanese Government bonds ended up in 2003 yielding just 0.44%.

The world, of course, is not necessarily like Japan. We must at least hope not. But it certainly looks less than wonderful at present. An already astonishing investment environment can be counted upon to throw a few more surprises our way.

Comments

[bosun.j:]

All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.

2008 Dec 05 06:15 PM

[gabe borens...:]

Basically ,Europe is experiencing the economic pain that the U.S had experienced .
The Continent had learned that the global economic cycle is driven by the U.S economic momentum or lack of(implosion)
Not too long ago ,the German leadership had implied that the U.S had lost its economic prowess and military power.
Clearly not so.In fact as we will learn by the second quarter of 2009,the Americans had implemented some very dynamic measures which will contribute to the first half of 2009 economic net expansion and a dynamic rebound by the second half of 2009 -I am sure of this .
Europe will not be able to make an economic trend reversal untill the U.S economy is on the path to full blown expansion.
In the meantime let's prepare for the Gabe mega rally (stock market).

2008 Dec 05 06:27 PM

[Urbane Gori...:]

If America isn't buying, then China isn't producing. If China isn't producing, then Australia and South America aren't selling their ores. If none of these are occuring, then Russia and the middle East are not moving their oil and natural gas. The Baltic Dry Index just hit $666 today. The sign of the Beast. The consumer is dead and the anti-Christ is upon us all! Please pass the Maalox...

jegan

2008 Dec 05 06:59 PM

[Tacitus:]

I can't speak to Europe, but for the last two weeks in the US mortgage brokers and bankers have been working around the clock, seven days a week, fourteen hours a day, on new mortgages and refinances in the residential mortgage business. The are having trouble keeping up with demand. Fed policy and the money being pumped into the banks and the economy are beginning to stimulate the flow of credit, and the ice floes are beginning to break up. Another rate cut on 12/16 and we will be past the worst of it. That's not to say the economy will snap back instantaneously, of that we don't still have some major systemic issues to address, but there is beginning to be good news among the bad.

2008 Dec 05 08:49 PM

[steveballmer:]

"We are where we are"
Man! Thats deep!

2008 Dec 06 04:58 AM

[You're Kidding:]

gabe borenstein said:

...as we will learn by the second quarter of 2009, the Americans had implemented some very dynamic measures which will contribute to the first half of 2009 economic net expansion and a dynamic rebound by the second half of 2009 - I am sure of this.
----------------------...

Sorry, but you are dead wrong, and I am sure of this.

There are tens of trillions of dollars in derivatives (to name just one of many problems) that must unwind first. This might delay the recovery a bit.

2008 Dec 06 07:47 AM

[bosun.j:]

rah rah rah sis boom bah! we're number one!


On Dec 05 06:27 PM gabe borenstein wrote:

> Basically ,Europe is experiencing the economic pain that the U.S
> had experienced .
> The Continent had learned that the global economic cycle is driven
> by the U.S economic momentum or lack of(implosion)
> Not too long ago ,the German leadership had implied that the U.S
> had lost its economic prowess and military power.
> Clearly not so.In fact as we will learn by the second quarter of
> 2009,the Americans had implemented some very dynamic measures which
> will contribute to the first half of 2009 economic net expansion
> and a dynamic rebound by the second half of 2009 -I am sure of this
> .
> Europe will not be able to make an economic trend reversal untill
> the U.S economy is on the path to full blown expansion.
> In the meantime let's prepare for the Gabe mega rally (stock market).

2008 Dec 06 11:59 AM

[update:]

Clueless Tacitus the bottom caller who regularily picks bottoms...

2008 Dec 06 05:11 PM