Last week was one which was full of new information for financial markets. Some of it of course was rather regurgitated as the Chairman of America’s Federal Reserve gave a speech to Congress which in the main repeated issues discussed in the minutes of the last Federal Reserve Meeting and minutes from the Bank of England which told us that they too were more uncertain of the future than usual. Uncertainty is becoming the new buzzword for central bankers is it not? We also saw a week in which world stock markets continued a recovery from the recent lows. The American Standard and Poors index for example fell early on Tuesday to below 1060 but ended a strong week at 1103. The most curious part of the equity moves was that earlier in the week they appeared to fall on good news and rose on bad. Either way it was a good week for them.
The UK had some genuinely good news at the end of last week or if I include the stress tests which reviewed UK banks very favourably with bankers at Barclays bank particularly wreathed in smiles I would imagine. A somewhat different result than what the real world stress test did to them some two years ago if you recall but remember Friday exchanged the real world for the views of European officials and civil servants! Anyway the economic growth figures were excellent with growth as measured by Gross Domestic Product rising by 1.1% and just to be clear this is for the quarter not on an annualised basis.
Breaking the numbers down revealed that construction spending grew by 6.6% and was responsible for 0.4% of the growth. I have been looking into this and it would appear that we did see a surge in the second quarter in this area but that quite a few factors were at play. For example the snow and bad weather in the first quarter shifted work into the second quarter and public spending was strong. So much so that it is not impossible that this figure apparently could be revised up (to create even more of a shock). However this is considered a peak as in essence going forwards we will have to see if private sector spending can rise enough to cover the retrenchment of the public sector. The real detail on this comes from a specialist blog called (probably unsurprisingly) brickonomics, however it/he has revised the view that many others quoted.
As a general view whilst the overall news is good it is also plain that the Office for National Statistics has problems with its data and its numbers. There was a considerable debate over when we came out of recession in the summer and autumn of 2009 and now we find growth way above even the most optimistic forecasts. Also this follows straight after the ONS having to delay publication of the final estimate of first quarter growth due to unspecified problems. I start to wonder if the staff cuts have had an impact and it is increasingly looking like an organisation which is in disarray. The way it refused to publish why it had to delay the GDP numbers looked straight out of the playbook of an organisation with something to hide.
A theme I wish to develop today is already in evidence here. When officials or civil servants try to hide something they often do it so badly that you end up with a worse result than if the truth had been told. Of course you also end up with an atmosphere of lack of trust and reduced credibility.
Monetary Policy Committee
One new feature in the UK is that members of the Monetary Policy Committee appear to be queueing up to be interviewed by the press so that they can say that they do not like inflation and that they are absolutely committed to dealing with it. Sadly with one exception their claimed determination to control inflation does not stretch to actually doing anything about it. So we have a verbal campaign it would appear.
As inflationary expectations are an important factor in dealing with inflation one might argue that they are trying to use an extra tool. However there are problems with this. For a start how many will read it? I would love to tell you that such interviews would be widely read but somehow I do not see it competing with page 3 of the Sun, or the football results. Also those who read such articles are likely in general to be aware of economic issues and accordingly be already aware that the UK’s inflation performance has been both poor and worse than expected over the past few years. Accordingly as they are reminding people of this then the plan to my mind carries within it the seeds of its own failure. For example from an interview given by the Bank of England’s Chief Economist Spencer Dale to the Independent newspaper.
Since the spring of 2006 inflation has been above target for 41 out of 50 months and for two years it has averaged over 3 per cent.”
“Inflation has come out a little higher than expected, and the news on VAT in the June Budget means that the time it will take inflation to get back to target will be pushed out, and I expect it will be above target until the end of next year.”
So having offered the possible explanation that this media campaign is trying to reduce inflationary expectations looking at the detail of it leads me to the conclusion that if anything it is likely to raise them. Why? I am afraid it is human nature as members of the committee are unlikely to admit it but when they are alone in a quiet moment they must be thinking to themselves that their term on the MPC is in danger of being considered a failure. So they are putting out individual statements to try to separate themselves from the group.However yet again such moves lead to everyone being worse off. I am grateful that Fabio Capello is not currently following this trend giving interviews to the press saying that England’s footballers really can pass to each other just like say Spain’s.
The European bank stress tests
I have established this theme today because over the weekend as I had time to review the stress tests in more detail this came to my mind. The thought occurred to me that Europe’s officials probably went home thinking that they had done a good job. I do not mean to imply that they are delusional simply that in my opinion they have trapped themselves in one of the “thought bubbles” I have discussed before. Time and time again we see EU and euro zone intervention which has what I consider to be extraordinary claims made by euro zone ministers and officials. These claims are usually punctured with in a few days yet sooner or later they are back again….
What actually happened?
These officials sat down and did not ask the question, how can we stress test the banking system? What they actually asked in my view was, how few banks can we fail? They in their “thought bubble” would have been in a zone where they saw the US stress tests as having been a success and will have wanted to repeat them as cheaply as possible. Then the markets would be reassured and everything would be better. What never seems to occur to them and lets face it this has happened quite often now is that as time goes by investors will stop and think. As they think they will see holes in the plan. So the pattern is for an inital rally followed by a fall. I find it profoundly disturbing that we have a group of people who appear to be running Europe who do not seem to ever learn from their mistakes.
Flaws in the tests
The most obvious flaw is the tests is the distinction between trading books and long-term holding books at the banks. You see holdings of sovereign debt were subject to a stress test if they were in the first category but not in the second. Now there are several flaws in this.
1. Banks usually hold more in the latter than the former category.
2. An old City aphorism is that ” a long-term hold is a short-term punt that has gone wrong”. Now this year a lot of short-term punts in sovereign debt have gone wrong. For example Greek ten-year government bonds yielded 5.72% as we began this year and now yield 10.58%. Put another way she issued a new ten-year benchmark bond on the 11th March at a price of 98.742 on average, it closed at 74.03 on Friday. That is quite a fall in 4 months. So before this stress tests were a twinkle in an EU officials eye banks would have been likely to have shifted such bonds into a long-term hold. Indeed some accountancy rules in Europe actually encourage this.
3, If you were a bank that is financially weak, once you knew that bonds which were going to be held to maturity would be excluded from the tests what would you do with your worst investments in sovereign debt?
4. Is CEBS actually going to check that the bonds are held to maturity? Is there a list so we can check?
So the sovereign debt section was already a farce before we reach the next part. In the “thought-bubble” of a euro zone official there is no reason to test what would happen if a country (aka Greece) defaulted because the moves they have made make this “impossible”. Indeed a logical man may worry about this conundrum. Default is most likely in the weakest countries. These weakest countries have supported their banks and provided capital. Should they travel along the road for default not only will their banks not have access to future capital from this source what will be the impact on existing capital that has already been provided? There is something of a Faustian flaw here.
Here the stress test was supposed to model how the banking sector would respond to a double-dip recession. According to CEBS.
The benchmark macro-economic scenario assumes a mild recovery from the severe downturn of 2008-2009, whereas the adverse scenario assumes a “double-dip” recession. For the euro area, the GDP growth under the benchmark scenario is assumed at a level of +0.7 (2010) and +1.5% (2011), whereas under the adverse scenario the euro area would see a decrease of GDP by -0.2% in 2010 and -0.6% in 2011. For the whole European Union (EU27) the benchmark scenario assumes a +1.0% growth of GDP in 2010 and +1.7% in 2011, whereas under the adverse scenario the GDP would not grow in 2010 and would decline by -0.4% in 2011. On aggregate and over the two-year time horizon, the adverse scenario assumes a three percentage point deviation of GDP for the EU
compared to the benchmark scenario. It should be noted that current macro-economic developments remain in line with the assumptions provided in the benchmark scenario.
In other words rather than a fall in GDP over the next two years of say 3% we get a fall of 3% relative to forecast figures. This is not the same at all. In fact it is a rather unlikely outcome and is misleading in my view.
Tier One Capital
Banks have been judged using a criteria of tier one capital and there are two main flaws with this.
1. This includes hybrid capital. You may be wondering what this is well it is capital that has elements of debt as well as equity in it. This leads to the view that they should be excluded as how can debt instruments help in a capital crisis? We are back to officialdom and “thought bubbles” again. Germany and Spain have supported their banks using hybrid capital so it had to be included.
2. Exactly what does having 6% of tier one capital tell us. For example if we raised it to 7% then another 17 banks would have failed.
Officialdom has got the result it wanted. Over the next few days as analysts slave over the numbers we will no doubt see examples of new more realistic stress tests being developed. Some banks will fail these and this has disturbing implications for there is the possibility that the stress tests will make things worse and not better. This is indeed a theme which euro zone officialdom is happy to ignore.
One market measure is already giving us a clue. This morning inter-bank markets have given a signal. Three month Euribor has continued its recent rising trend and is now 0.889%. Still low compared with the post-Lehman crisis but no sign of an improvement.
In reality as I wrote last week stress tests can never fully replicate a real world “stress” which by definition is unexpected and these days is often fast-moving and dynamic but a chance to re-establish some credibility has been missed. Furthermore there was another flaw. These tests dealt with capital (copying the US 2009 tests in this regard) and the current problem is liquidity. But then there is another aphorism “central bankers always fight the last war”.
Sports fans who watched the formula one race from Germany were given further food for thought. The race was manipulated to give a Spanish winner. Those in any doubt of this should have seen Felipe Massa ‘s body language at the end of the race. I have heard of art imitating life but sport? No doubt Ferrari like euro zone officials felt they had been very clever whilst fans were wondering if they had just been cheated.