It looks like Kris Sayce will be buying us those three beers after all…
You’ll recall that the wager we made last week with our colleague down the hall was whether or not the Fed would raise the Fed Funds rate in the next three months. Your editor – based on his vast knowledge of the Fed – reckoned no. Kris reckoned so.
So far, it looks like we’re going to win. Ben Bernanke fronted Congress yesterday and called the U.S. economic recovery “nascent.” That seems pretty generous, given that January new home sales fell 11.2% from the month before the lowest-ever level on record. That sounds like a second housing bust, more bank losses, and the increased deleveraging of American households.
Markets didn’t hear any of what we heard though. The S&P 500 was up nearly one percent. And to be honest, we know as much about the future as the next guy: nothing. It could be that the Fed chairman is right and consumer demand will slowly recover and things will be rosy again.
But remember, the central bankers telling us that America’s recovery is “nascent” and that Australia will benefit for many years from a “very big” investment boom in the resources industry are the same blokes who did not give you a single warning about what was coming in 2007 and 2008. Why is that?
They weren’t looking hard enough. The blame for the global bust has fallen on too much leverage and too much speculation. A deeper blame falls on the structure and the ethics of the modern economy itself. It seems to favour debt and speculation and reward money shufflers. But that doesn’t tell the whole story either.
The whole story begins with the manipulation of interest rates. The credit cycle – in this case lowering interest rates to avoid the necessary liquidation of bad investments – is what turned the dot.com crisis into an American housing crisis. Securitisation and credit default swaps turned it into a global problem infecting the whole financial system.
But the central bankers refuse to acknowledge that booms and busts are predictable if you study the credit cycle. Maybe they do understand this, of course. They just don’t want anyone else to understand it. How else could Alan Greenspan take himself seriously by telling us this is the worst financial crisis ever – but not acknowledging his indispensable role in making it possible?
However maybe we’ve been couped up in our St. Kilda redoubt for too long. So we’re hitting the air and on our way to freezing, snowy, Baltimore to meet with some colleagues and discuss what to do. We already have a plan.
In the meantime, Australian markets are motoring along contentedly. In fact the economy has recovered so nicely that several investment banks are worried that the government deficits are going to be smaller than expected and that – get this – there won’t be enough government bonds to satisfy market demand.
Quick! Borrow more money so the bond market is happy!
Figures from Deutsche Bank and Citigroup both show the annual fiscal deficits being smaller than expected through 2016. These smaller deficits (they’re not going away entirely) are presumably the result of increased royalty income from the commodity boom, a favourable terms of trade, and solid GDP growth. Spending probably won’t go down much, if at all. But national income will go up. Anyway this is what the banks have looked into the future and seen.
Yesterday’s Financial Review even mentioned the possibility that a shrinking government bond market would be a problem for Australian banks. That’s because a new regulation proposed by the Australian Prudential Regulatory Authority (APRA) would require a certain percentage of bank assets to be made up of high credit quality bonds.
Only government bonds (sovereign debt) would appear to satisfy the requirements. This is convenient for big borrowing governments. A similar rule in the UK is under consideration and it provides the government there with a similar captive market for its bonds. The banks must, by law, own some government debt.
But what if Australia’s government isn’t borrowing enough to meet bank requirements for “safe” government debt. To be honest, we’re not losing any sleep over that problem. Australia’s demographic dilemma is not as acute as other countries. But with an ageing Baby Boomer population, you can surely expect higher aged pension and health care expenses at the federal level. That’s going to take some borrowing.
But yesterday’s article – and we can’t give you a link to it because there isn’t one – said an alternative is being discussed. You’ll never guess what it is…mortgage backed securities!
No kidding. With a straight face, someone has apparently suggested that the best way to improve asset quality for Australian banks is to make them buy mortgage backed securities. Are you kidding?
The banks set up other companies to engage in the non-traditional lending business precisely because they don’t want that stuff on their balance sheets to begin with. It’s hard to imagine you’d improve the quality of bank assets by forcing them to take on more assets that are collateralised by real estate. Remember…that did not work out so well for American banks did it?
But then, Australian house prices never fall. So perhaps collateral securitised by Aussie houses is, well, safe as houses. But you wouldn’t want to be the solvency of the banking system on it, would you?
for The Daily Reckoning Australia