The Bank of England has published the latest issue of its twice-yearly Financial Stability Report. The Financial Times leads on the story under the optimistic heading “Bank of England Signals Worst Is Over.” The report’s argument was summarized by John Gieve, the deputy governor of the bank: “While there remain downside risks, the most likely path ahead is that confidence and risk appetite will return gradually in the coming months.” The bank’s optimism extends even to the U.S. housing market.

Even with a further decline in U.S. house prices, the bank does not expect any default in AAA-rated subprime mortgage-backed securities. That means that those securities are significantly undervalued and that some of the writing down has been much greater than necessary.

This optimistic review was published on the day that the Federal Reserve cut interest rates by a further quarter percentage point, to 2%. This was only slightly mitigated by the Fed’s hint that there might be a pause in rate cuts at the next meeting, in June.

There is now a very wide gap between the interest rate philosophy of European central banks, including the Bank of England, and the U.S. Federal Reserve. The Europeans have shown little willingness to counter the credit crunch by large and repeated interest rate cuts. The Fed has continued to follow the much-criticized Alan Greenspan policy of cutting rates early and often.

The pessimistic American view is supported by most New York opinion. Jim O’Neill, the chief economist of Goldman Sachs, says that Britain is “in the eye of the storm of a deleveraging world economy… The U.K. mortgage market is effectively frozen. House prices are going to go through negative changes. It’s going to be a challenge for U.K. policymakers.” This American view has even penetrated to the Bank of England’s Monetary Policy Committee, where an American member of the committee, David Blanchflower, has said that a 30% fall in house prices by 2010 is not implausible. Such a fall would be comparable to the fall in house prices in the United States.

My own view is that the Bank of England is probably premature in spotting a turn in the market. For some time yet, banks will be rewriting their capital bases. They will be concerned to reassure themselves and their customers about their own financial situation and will, therefore, remain risk averse and reluctant to lend. The banks have had a very nasty fright, in which it was impossible to value major investments and difficult to be sure of the true solvency position of major banks. That was a global phenomenon.

It may be true that the worst of the immediate panic has passed, but the mood of caution, even of exaggerated caution, has not. There are also, in the U.K., problems with the falling valuation of commercial property that are as worrying as the concerns about U.K. residential policy. The Bank of England wants to help restore confidence, but it will take time for banks to return to their more relaxed attitude to the lending risk. Indeed, the Bank of England would not want them to go back to the mood of 2006, when lending standards were too low.

However, the European view is not merely one of optimism about the future trend of asset values, but one of greater pessimism about inflation. Record prices for property may have peaked; some commodities, including gold, have reacted, as well. But energy and food prices are at record levels and have not yet turned down.

European bankers remain relatively anxious about the threat of a return to inflation. That is why European Central Bankers are reluctant to follow the Fed in cutting interest rates. The Bank of England is also worried about the rising budget deficit of the British government. High interest rates tend to offset the inflationary effect of the deficit, which itself seems to be rising by the day.

I find it easy to see the pessimistic case. I expect the U.K. housing and commercial property markets to continue to fall. In London, they are very closely linked. I expect the U.K. budget deficit to continue to rise. I expect Bank of England interest rate policy to remain cautious, as will that of the European Central Bank. I expect these financial conditions to continue in 2009, and probably 2010, as well. There is not all that much encouragement for optimism.

Regards,
Lord William Rees-Mogg
May 1, 2008

Fed Effects on Europe was originally featured on Whiskey and Gunpowder

“…If Bernanke was expecting a 13% rise on Wall Street, he’s got a 45% rise in gold instead — plus a real disaster in U.S. Treasury bond yields…”

THIS WEEK MARKED THE SIX-MONTH ANNIVERSARY of the Fed’s first cut to U.S. interest rates during the current world-banking crisis.

And it’s been fun, fun, fun ever since for hard asset investors.

Aimed at promoting “orderly conditions” in the world of finance, that 0.5% cut to the Fed’s discount rate kick-started the sharpest collapse in dollar interest rates since…well, since the last time it tried to restore order to the value of U.S. financial assets.

But while short-term money markets remain tight six months later — and the subprime panic has since spread to “monocline” bond insurers, private equity groups, pan-national banking giants and even U.S. student-loan finance — the only order so far has come in raw materials, rather than finance.

A big fat order of whopper-sized gains, in fact, with a fried egg on top for good measure…

The price of gold meanwhile — whose only real utility, unlike all other natural resources, is as a store of value — has now risen in 20 of the last 27 weeks. Spot gold prices have gained 44.7% since the morning of August 17, just before the Fed announced its “extra-ordinary” rate change.

Whereas the S&P500 stock index has dropped 7.5% of its value. Which surely wasn’t the plan.

“Even the casual observer can have no doubt that FOMC decisions move asset prices, including equity prices,” said Ben Bernanke in a speech of Oct. 2003. “Estimating the size and duration of these effects, however, is not so straightforward.”

Then a mere Fed governor, rather than the big cheese himself, Bernanke related a pile of highly detailed and utterly pointless research he’d done with Kenneth Kuttner of the NY Fed. In short:

“The statistical evidence is strong for a stock price multiplier of monetary policy of something between three and six, the higher values corresponding to policy changes that investors perceive to be relatively more permanent. That is, according to our findings, a surprise easing by the Fed of 25 basis points will typically lead broad stock indexes to rise from between 3/4 percentage point and one-and-a-half percentage points.”

Oh sure, Bernanke was talking about the kind of gains he’d expect to see inside one day! But slashing the Fed funds target by 225 basis points since the global banking crisis provoked him to act back in August, Bernanke hasn’t even got 6.75% across six months…let alone a 13.5% rise on Wall Street.

He’s got a surge in the cost of living instead, driven by basic raw material prices. And that’s bad news — as in gruesome — for Treasury bond owners:

Yes, the Fed’s overnight lending rate — as well as short-term Treasury bond yields — tipped sharply negative after accounting for inflation during the Greenspan “emergency” of 2002 to 2005.

But longer-dated U.S. Treasuries — those bonds used to fund the vast bulk of Washington’s on-going finance needs — only briefly failed to keep pace with the cost of living. Unlike now.

Today they’re lagging inflation, and threatening to lag it badly:

The last time U.S. Treasuries paid a whole lot less than inflation, the crisis got so bad that government bonds became known as “certificates of confiscation.”

Money failed to flee into equities, however, even as the United States faced the very real prospect of being unable to find the cash to fund its government spending. To fix this mess in the world’s No.1 economy, it took a collapse in nominal bond prices — driven by record-high interest rates from the Fed — and the longest recession since the Great Depression to restore America’s credit.

Just how miserable might the real returns paid to bond-buyers become if inflation keeps rising today? The runaway producer price index, backed up with $100 crude, stood right behind it wearing knuckle-dusters, growling that things are about to get ugly.

And just how far might hard asset prices go as investors flee stocks, bonds, cash and property all at once…?

Yes, the current surge in gold prices looks a lot like that infamous “cathedral top” of 1980, right?

Gold spiked above $850 per ounce in the spot market in 1980…and then fell almost every year for the next two decades.

But the move above $800 per ounce came and went inside three days. And the run-up saw gold prices more than triple on their monthly average in little more than a year. Here in Feb. 2008 — and with US Treasury yields turning negative once again — gold has taken more than half-a-decade to repeat that feat.

Too much, too fast? With Bernanke at the Fed — and $100 oil heading for the pumps, as well as for real bond yields — just maybe we ain’t seen nothing yet.

Regards,
Adrian Ash
BullionVault
February 27, 2008

Inflation and Treasury Bonds was originally featured on Whiskey and Gunpowder