RBA Says Financial Conditions Are “Substantially” Tighter

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There was nowhere to hide today on Wall Street. Everything was down. Financials, retailers, commodities, yield plays… it all went south. It’s a disturbing sign that the Street may be on the verge for a fourth down month in a row. And here in Australia, the Reserve Bank showed no remorse to local homeowners, raising rates for the 12th straight time to their highest level since 1994.

The cash rate is now 7.25%. But after yesterday’s rise, there are probably more questions than answers. In its statement, the RBA said that overall financial conditions were “substantially” tighter than last year. You can say that again. Credit spreads are widening again, which is a complicated way of saying the same liquidity fears that became so acute last August are back again.

“The second leg of the credit crunch looks to be even uglier,” reports the UK Telegraph. “Asset-backed, Commercial mortgage spreads met ‘ebola,” reports Bloomberg. “Yields on three-year, AAA rated credit-card bonds with floating rates rose to 75 basis points over the London interbank offered rate, up from 40 basis points at the start of the year, according to Deutsche Bank AG data.”

Yep. Financial conditions are definitely a lot tighter than even just a week ago. Banks are absolutely terrified of lending anyone any money. More on that below. For Australia, there was at least some good news from the RBA. It didn’t raise rates by 50 basis points. Remember, it thought about doing that in February.

So is Glenn Stevens going all Wayne Swan on us, feeling our rate pain and holding back just a bit on his tough love strategy? No. The Reserve Bank said it has seen some evidence of moderating demand. And on cue, the Australian Bureau of Statistics reported that January retail sales were $20.14 billion-unchanged from the Christmas shopping month of December.

Banks are still stingy. Check. Consumers aren’t increasing spending. Check. But what about inflation? That’s what the RBA is worried about. And before it can stop raising rates-or ye gads-even cutting them, there has to be evidence that inflation is under wraps.

You won’t find that evidence in the oil market. Crude hit a new all-time high over $103. It was higher than its 1980 inflation-adjusted high. Today’s GDP figures will probably show slower fourth quarter growth here in Australia. But will it be enough to halt the Reserve Bank’s stern hand?

The Bank will probably wait until first quarter CPI figures come out before it decides what to do next. So what will stocks do in the meantime? Well, up until now the market has been torn between two themes: the bear market in credit and the bull market in resources. We’ve taken the liberty of expressing the idea in pictures below.

The chart shows the banks stocks (NYSE:BKX), versus gold and sliver (NYSE:XAU) and the S&P 500 over the last year. Resources are up. Financials are down. The market is caught in the middle.

This is even more true in Australia, where there are more resource stocks listed, but the banks make up a larger portion of the market’s total capitalization. Bull markets hum along when investors have easy themes they can harmonize with to justify buying stocks. But when you’re caught between themes, there is discord. It’s not a pretty sound, or a pretty sight.

And Ben Bernanke isn’t making things any better. The Fed Chairman managed to scare even resource bulls yesterday. Bernanke said in a speech that, “Efforts by both government and private-sector entities to reduce unnecessary foreclosures are helping, but more can, and should, be done.” Here’s the scary part. “Principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure.”

The Fed chairman wants banks to write down the value of loans they’ve made to restore equity for homeowners who currently don’t have any. You’re home’s market value is lower, but that’s okay, we’ll lower your loan amount too. Getting some mortgagees out of negative equity might allow them to refinance into a new loan at lower rates-especially if the Fed lowers again as the market expects.

Maybe it’s a creative suggestion. But hearing America’s central banker all but admit that something must be done-and soon-to prevent another wave of foreclosures from destroying the collateral behind billions more in securities is not what the market wanted to hear. Stocks in America responded by retreating to 18-month lows.

It would be nice of banks could just forgive and forget all those bad loans. But financial markets are not sweetly sentimental. The only real way out of a situation where credit has been badly misallocated is to write down the losses and purge the system of rot. In real terms, though, it is now clear to everyone what that means: the end of many people’s dreams of homeownership in America.

And in Australia? More on that tomorrow.

Is there a way out of the mess? Our friend and former banker Chris Mayer is pretty level-headed about the whole thing. Chris has written a new book about how to find good companies. We have a copy here on our desk at The Old Hat Factory. It’s called “Invest like a dealmaker: Secrets from a former banking insider.” Please check it out.

We’re headed across the Tasman in a few hours to speak to some American investors looking to make an escape from America. Actually, they are looking for better places for their capital, while they still have the flexibility to move it out of America and its declining currency. What will we tell them?

We are going to introduce them to the “Lilly pad strategy.” We mentioned that in Jo’burg, getting around wasn’t that hard. But it WAS like driving between one gated business park and another, sort of like 21st century feudalism, with walled business cities and dangerous roads between them.

The picture of safe commercial enclaves in vast oceans of geopolitical instability is not a bad one for where we think the world is headed. For investors, this means you have to pick your islands carefully. But if you do, you can find quality assets in each place, and hope to them like a frog, from Lilly pad to Lilly pad.

What does that really mean? Well in the last year we’ve found quality businesses on our travels in four different continents, in Africa, Asia, Australia, and North America. Putting those assets together in a strategy to survive the bear market in credit is what we call the “Lilly pad strategy.” More on that from Auckland tomorrow.

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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