What’s Under Bernanke’s Kilt?


Our Australian friend Joel Bowman over at Daily Reckoning America put together this display of metaphorical brilliance:

Investors have been suffering through a dazzling display of mixed signals lately. One minute they think the market’s got the hots for them…the next minute it’s throwing cold water in their face. It comes on strong…then plays coy. Shows some leg…then slaps a cheek. Last week investors got whacked. This week they’re all doe- eyed again. They think they’re in love.

Most folk don’t like all the games. “A simple ‘Yes’ or ‘No’ would do us just fine,” they say. “Think of all the time and money a straight-forward answer would save if the market would just pick a path and stick to it!”

Ah…but where’s the fun in that, Fellow Reckoner? Where are the lessons along the way…the travails of the journey…the hardships to look back on through the rose-colored glasses of retrospect…the glory days to romanticize at some distant date in a far off future?

More importantly, what would we have to write about all day if everyone already knew the headlines of tomorrow’s papers? Who’d bother asking any questions? Not us.

Fortunately, that’s not the way markets work. The relationship is far more complex than that.

Harsh words. Harsh but true.

Let’s stick with the flirtatious metaphor. On Wednesday, perverted central bankers went well beyond showing the markets some leg to tempt investors into buying. Instead, Bernanke and his prurient friends at the central banks of Europe, Japan, Switzerland, England and Canada full on flashed investors. It had the desired effect with indices up the most in one day since March 2009.

But if anyone had looked more closely, they would have been disappointed. The announcement was about the puniest intervention central bankers have come up with so far. It wasn’t quantitative easing. It wasn’t even an interest rate cut. It was an interest rate cut on emergency lending that takes place via something called a currency swap. In other words, they made US dollar borrowing cheaper for foreign central banks and thereby the banks they lend to in ’emergencies’.

Peter Tchir, from a firm called TF Market Advisors reckons “…more people just bought stocks than know what a central bank swap line is.”

Strategic Short Report editor Dan Amoss explained the reason for the intervention: “… there has been a shortage of U.S. dollars available to borrow in Europe. U.S. money market funds have basically stopped lending to European banks… So the Fed is stepping in, offering generous loans to the European Central Bank, which is, in turn, relending those dollars to European banks.”

This is not an improvement. It is a simply preventing a further deterioration … for now.

And here’s the big problem with the latest interventionist ‘solution’: Lowering swap rates doesn’t solve any of the problems festering on banks’ balance sheets. We wrote about them last week in our article about the banking crisis. The crisis is not about banks’ ability to earn cash. It’s a solvency problem, not a liquidity problem. The assets of banks are deteriorating relative to their liabilities. This is much the same as a person owing more on their house than it’s worth. Giving them more cash doesn’t solve the issue.

Of course, solvency problems eventually turn into liquidity problems. That’s how they come to a head – a climax. And that’s where those raunchy central bankers come in. When banks can’t borrow from the private sector to pay off maturing debt, they either go bankrupt, or go begging for favours from central banks.

But central banks require collateral to be posted with them for certain types of emergency lending. Like the swaps that all the hubbub has been about this week. So the Bear Stearns and Lehman Brothers of the world can in fact fail if they don’t have enough quality assets to cough up as collateral. And the crash alert flag was raised to half mast on Wednesday when changes to collateral requirements began making news.

According to the Financial Times‘ regular video discussion, central banks eased collateral requirements on Wednesday, ‘…reducing the amount of collateral that’s initially needed against foreign currency loans.’ Reuters reported the opposite, saying there was no change yet. Finance professionals quoted ad nauseam in this Telegraph article reckon changes to collateral are in the works.

The changes that either have been made, or are about to be made, will relax what and how much central banks will accept as collateral in lending agreements. This will make it easier for banks holding dodgy assets to borrow money. But the assets are still dodgy.

The fact that the collateral rules are being changed indicates something is wrong. Someone has too many dodgy assets.

The Financial Times video also points out the policy of lowering currency swap interest rates hasn’t worked in the past. The change leads to a short lived stock market rally at best. So the central bankers have come up with a short term fix for a long term problem. Like painting dirty walls before selling a house. With any luck, it will be someone else’s problem.

Then why did markets rally so hard? Firstly, it was a coordinated intervention by a group of central banks. Financial markets like this in the same way female gorillas like to see their alpha male beat his chest. Secondly, the intervention buys time for any bank that is really desperate for funding.

But the market is getting ready to slap some cheeks now that so many investors are in the market with their heart on their sleeve. So here is our financial advice: You should play very hard to get. Don’t let an attractive pair of legs fool you. That skirt is really a kilt.

But if you do want to join in the fun and get in the market, do it in the right places. Conventional investment wisdom thinks financial markets are safe because infinite amounts of cash can be created by central banks to paper over any problems. What could possibly go wrong?

Of course, common sense says holding things that cannot be created infinitely is the only safe investment strategy in times of fiat money creation.

Nickolai Hubble.
The Daily Reckoning Weekend Edition

Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.

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4 years 10 months ago

All true. The bank I use is increasing TD rates as they cn’t actually raise the money cheaply overseas. Not many people know that yet. I won’t lend them more than Swannies guarantee though. I just don’t trust them anymore with big gobs of money.

If you don’t know what repos, and CDSs are, or who J. Corzine is, or how to buy unallocated Au, you probably should stick to TDs for now.

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