Yesterday was a day of two halves with a shock just around midday UK time followed by another one a couple of hours later. And in spite of my football reference I do not mean the developments in the Wayne Rooney saga, as I suspect that real shock there came when Sir Alex Ferguson explained to Wayne what he thought about him claiming to be fit when Fergie had said he was suffering from an ankle injury and that happened last week. Indeed many would pay to be a fly on the wall in that room at that time! No wonder Wayne seems a little shell-shocked these days…
No the first shock for financial markets came with the following news. The People’s Bank Of China caught markets off guard on as the central bank raised its one year lending and deposit rates by 0.25% to 5.56% and 2.5% respectively in what was the first official tightening move since 2007. The domestic impact looked like an attempt to suppress inflation expectations and maybe also to dampen further China’s property market, however I did wonder if there was an external influence connected to the “currency war” saga which is developing. Also it did occur to me to wonder if there was a significance in the announcement following hard on the heels of a profits report from Bank of America, as China does like symbolism. Just to add to the atmosphere of currency issues I spotted this in a speech given by Bank of England Governor Mervyn King yesterday. Please remember that this is in central banker speech and so if he is saying this we can conclude that the reality was worse.
Tensions between the two groups were evident at last week’s IMF meetings in Washington where all the talk was of currency conflicts
A couple of hours later came developments in the foreclosuregate scandal and a much less optimistic speech from a Federal Reserve President than we have become used to recently. More on those later but the effect on many markets was severe. Equity markets fell with the Dow Jones Industrial Average falling some 165 points to 10978 and this was followed this morning by the Japanese Nikkei 225 equity index falling some 157 points to 9381. In the world of investment correlation in which we live at this time where there is little investment diversification we also saw the US dollar index rally whilst the price of gold and crude oil fell too. I was sent a chart by a friend with his thought on this area and it shows gold, the US dollar/Japanese Yen exchange rate, and the US stock market moving in step, or a type of dance.
The Foreclosure scandal in the United States
I wrote an article on this subject on Friday the 15th of October and yesterday an already worrying situation deteriorated further. After some figures from Bank of America which were being digested came news that even the Federal Reserve Bank of New York- yes part of the central bank- was a signatory to a letter which stated that it and some other investment companies including Black Rock and Pimco feel that they can legally force Bank of America to repurchase some US $47 billion worth of mortgages which had been packaged into Mortgage Backed Securities by its Countrywide Financial subsidiary. As you can imagine this had quite an impact and reminds me of my comment on the 15th October about the credit-worthiness of the Federal Reserve’s balance sheet.
In its attempt to shore up the US financial system the Federal Reserve bought some US $1.5 trillion of MBS’s and many US taxpayers may well be wondering exactly what these are now worth.
It would seem that the Federal Reserve is now worried too and via its Maiden Lane subsidiary which holds these bonds it looks as though it feels that legal action is now necessary. Also there is a further irony in this issue as Black Rock is 34% owned by Bank of America! So it must be fairly sure it is correct to be taking such a step. On this basis it is no surprise that Bank of America’s shares lost 4% on the day particularly if you notice that it had in the figures it released reduced its provisions for such matters by some US $376 million. Such is the fantasy nature of banking at this time, in my view I hasten to add.
The President of the Dallas Federal Reserve appears to have been reading my script and not the one given by Ben Bernanke!
In an interesting development and one which may have contributed to the market falls we saw yesterday Mr.Fisher said the following which was very different to recent Fed. speeches.
And because the professional economists among you know as well as I do that John Kenneth Galbraith was not all that far off when he divulged that “economic forecasting was invented to make astrology look respectable.”
There was already some significance in this as if you believe this you are much less likely to be pushing for more monetary action as you would wait for more data. So already Mr.Fisher was hinting that he was unlikely to be a supporter of the so-called QE2 that many of his colleagues have spoken out in favour of. Just to reinforce his doubts we then got.
The problem is that, presently, the efficacy of further accommodation using nonconventional policies is not all that clear.
In other words he has doubts because he is not sure what,if any,good such a policy would do. But then we got the most stunning part of the speech which said the following.
In my darkest moments, I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places.
This is a more chilling prescription and those who have read my section on Quantitative Easing over the past eleven months will know that I share the fears expressed in that last sentence. But then Mr. Fisher went on to express fears about a moral hazard I have long highlighted, rewards to debtors and punishment for savers from organisations which have long asked for more saving!
A great many baby boomers or older cohorts who played by the rules, saved their money and migrated over time, as prudent investment counselors advise, to short- to intermediate-dated, fixed-income instruments are earning extremely low nominal and real returns on their savings. Further reductions in rates earned on savings will hardly endear the Fed to this portion of the population.
Moreover, driving down bond yields might force increased pension contributions from corporations and state and local governments, decreasing the deployment of monies toward job maintenance in the public sector. Debasing those savings with even a little more inflation than what is above minimal levels acceptable to the FOMC is also unlikely to endear the Fed to these citizens.
So this is a thoughtful speech and even includes a reference to the damage that is being done to pension schemes by current policies which is often ignored, presumably because it is not well understood. In the case of the UK then a pension scheme,of the defined benefit type, has to use a AA corporate bond rate to value its liabilities so if the interest rate falls the size of your liabilities rises and of course interest rates have been falling. So when you read of pension fund deficits at this time some of them have been caused by the current situation and it is a by-product of official policy. Also if you look at the very concept of a AA rating it was brought in just in time for such ratings to be completely discredited was it not?
Mr.Fisher ends with a “then the potential political costs relative to the benefit of further accommodation will have increased”. So I think that we can safely say that he is troubled by the apparent rush for QE2.
The picture has changed somewhat over the past 24 hours as it is plain now that there is a camp at the Federal Reserve which does not support the apparent consensus for extra asset purchases or QE2. Whilst Mr. Fisher does not have a vote until 2011 (in an accident of timing how annoying might that be for him!) he is likely to have influence and it is not only the UK central bank which is split three ways.
As to the currency situation it is interesting to note Mr. King’s comments as they are likely to be understated and I think that we can guess the real situation which may be even worse than I thought.
The situation of foreclosuregate seems to have sneaked up on the blind side of many investors. I am not a legal expert but I find it hard to see why the Federal Reserve Bank would be writing such a letter unless it was sure of its grounds and Black Rock would think hard before writing such a letter to a company which owns 34% of it. Should it develop in the way of previous banking problems then there may be a lot more to come as I am reminded of the way that bad news for Anglo-Irish Bank was fed out gradually in the manner of extracting teeth and perhaps I am being unfair to dentists as anaesthetics are much improved these days!
I will also be updating today on the UK situation and our spending cuts but will write a separate update on what is a busy time…