Michael Howell argues that there's nothing new or unusual about the credit crunch, nor about the action needed to recover
This crisis is part of a 'normal' credit cycle. It is a classic refinancing crisis and not a deeper insolvency crisis. It has felt more vicious in part because of the forced 'marking-to-market' of bank asset values: a feature absent from other crises, and which created a negative feedback loop. The solution is straightforward: more liquidity and sustained steeper yield curves. The consequences are lower interest rates and ultimately a much stronger gold price; a wake-up call for Europe, and probably the 'renationalisation' of central banks by finance ministries.
Stockmarkets will not recover before money markets do. Lying at the heart of this credit crisis are dysfunctional money markets. They highlight a liquidity problem, not yet a solvency problem, although plainly both may be connected by time. The longer these disruptions persist, the greater the odds of severe recession.
We figure the cause of the problem is the fragile funding of money markets, rather than profligate lending by bankers. Central bankers' fixation with interest rate targeting, errors in choosing the right target and mistakes in not altering interest rates quickly enough, resulted in huge swings in money market liquidity. Thus, attempts to fix the cost of credit resulted in wild gyrations in its quantity. After the millennium and then 9/11, money market liquidity soared so high it encouraged many lenders to change their funding models. The post-2005 progressive slump in money market liquidity wrecked these new business models and destroyed confidence. The modern day equivalent of a high-street bank run is the equivalent exit from the wholesale money markets. It is less visible but just as painful as liquidity and funding rapidly dry up.
Financial market liquidity is fed by savings and by central bank injections, and in troubled times it is drained by real economy inflation and by hoarding. In the 1970s the scourge was inflation. Today, in an eerie parallel to the 1930s, the problem has been weak central bank liquidity and a sharp rise in hoards. But this credit crisis is not simply a US problem. It embraces the entire rich developed world. Therefore, all major economies must act. Rising liquidity and low real interest rates lie ahead. Gold responds favourably to both. The solution in the 1930s was a higher gold price. And, before this crisis is history, we figure that a $2,000/oz price is likely.
High gold prices, low interest rates and rising liquidity will remain a key part of our future because the economic world is changing. It has been our central argument over recent years that investors must increasingly adjust to mature capitalist economies. As we see it, financial markets have changed from being traditional capital-raising mechanisms into capital-distribution and, sometimes, capital-destruction mechanisms. The world needs to reshuffle capital from West to East. On top, banking markets have become credit users rather than solely credit suppliers. The driver is a secular decline in the return on industrial capital, the seedcorn for financial returns, as it is hammered lower by competition from emerging economies.
Consequently, there has been an increasing demand for financial leverage to flatter dull underlying returns in the West - particularly to service existing investment products with guaranteed commitments - but also a parallel collapse in the demand for credit for genuine new industrial investment. Thus, banks and financial markets had to reinvent themselves.
Japanese banks and Tokyo's financial markets first faced this challenge in the early 1990s. Their US and European counterparts are now struggling to do the same. As we recently argued, this is being made more difficult in the face of an archaic policy regime run by blinkered central bankers. We may face a 'normal' credit cycle downturn, but the stakes are higher.
Thus, there is a pressure for policymakers to act. Unexpectedly, American markets and politicians initially blanched in the face of Treasury Secretary Paulson's $700bn TARP bailout package. They need not have. The bailout plan may be an important part of the solution to the credit turmoil, but it is not critical. Fundamentally, this crisis is first and foremost a classic refinancing crisis, which gums up money markets. Therefore, it is more down to the US Fed to fix (indeed, that was why central banks were originally set up!) than the US taxpayer.
But the US Treasury has become involved because the Fed has dithered. For too long it has had its eye off the liquidity ball. The roots of this crisis go back to the substantial expansion of US Federal Reserve credit under former chairman Greenspan ahead of the millennium (+15.6% in prior 12 months) and after 9/11 (+8.9% in following 12 months). The resulting flood of liquidity into US money markets tempted far too many lending institutions to feast on this cheap and unending credit, tying their business models to mercurial market-based funding and switching away from the more reliable, if more prosaic, bank deposits. When Bernanke inadvertently called time on the party, the sky fell in.
We have been here before - sadly, too many times.
The way ahead
The solution is straightforward. It may already be at hand, but it will take time. History shows there are three ingredients to the remedy:
- Liquidity - more central bank liquidity to raise the quantity and improve the quality of existing credit.
- Spread - Steeper yield curves, and we suggest at least a 200 basis point spread between 10-year and three-month money.
- Time - two to three years operating this policy stance.
The result of all past global banking crises, such as the early 1980s, early 1990s, mid-1990s and early 2000s was sustained periods of two to three years of at least 200bps time/duration spreads in yields. Alongside, central banks added plentiful liquidity at the short end, evidenced by strong monetary base growth in the six months following banking crises.
Over a two to three-year period, base money needs to be at least 20% higher. In the case of this crisis, the Fed has failed to sustain its action. Base money dropped from 5% higher one month after the credit crunch began to emerge in July 2007 down to only 0.5% higher eight months later.
Global yield curves will follow the US lead by steepening. The move from flat and inverted to steep curves is always a bullish period for bond markets, with long yields dropping particularly as the curve moves from a flat to steep position.
US and Japanese long-dated yields may drop slightly, but the greatest scope for capital gains lie across the European bond markets.
Yield curves will steepen largely because of rising liquidity, but a rapid means to expedite a steepening is for policymakers to announce some sharp interest rate cuts. Paradoxically our main point is that central banks must ultimately jettison their preoccupation with trying to set interest rates and focus more on pumping in much-needed liquidity.
The pattern of yield curves suggests that economies are also moving sequentially, with the US at least six months ahead of Europe. Assuming that the long end of European and US bond markets ultimately converge at around 3.5%-4% yields, US rates could be cut by another 50bps, but then ECB interest rates would need to be slashed by a whopping 150-200bps from here. How could central bankers have got things so wrong?
- Michael J Howell is managing director of CrossBorder Capital.
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