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Tuesday 19 March 2024
Last week, the US dollar fell to its lowest level on a trade weighted basis since records began in 1973. I expect the dollar to continue its decline.

On the one hand, we believe there will be more US interest rate cuts than the market is pricing in (the market’s anticipating about two 0.25% rate cuts by this time next year, and no more thereafter). We’ve posted a number of comments explaining why there is a very real risk of the US entering recession (for example see US house prices experience record fall, or will this financial crisis send the US economy into recession). If there is a sharp slowdown or recession, expect the Fed to react very aggressively.

From the technical side, the effects of globalisation have weakened the world’s reliance on the US economy. As I commented in Top dollar no more in November last year, the development of Asian countries’ economies and financial markets will reduce Asian investors’ reliance on US dollar assets. Asian demand has been a fundamental support for the US dollar over the past decade, and a weakening of this pillar will have big consequences.

US investors have reacted to the steady weakening of the US dollar by putting more money in overseas equities than ever before. The US trade deficit stood at -5.5% of US GDP in Q2, which is an improvement on the low of -6.8% at the end of 2005, but in light of the above it looks like the dollar will continue to weaken for the foreseeable future.

The Bank of England’s controversial decision to bail out Northern Rock depositors, which was probably necessary to prevent a UK banking sector collapse, has done very little to halt the slide in Northern Rock’s equity price and for good reason. The Bank of England has been clear that its rescue is only a temporary measure, and Northern Rock’s potential to write new business and take deposits is therefore very limited, meaning that Northern Rock’s business model is no longer valid.

Financial bonds have significantly underperformed other investment grade corporate bonds over the past few months, with Tier 1 bank bonds (which are subordinated bank bonds) performing worse than single-B rated bonds during the credit sell off (click to enlarge). The average spread on UK Tier 1 bank bonds, which are rated about A- on average, is 236 basis points at the time of writing. Tier 1 banks are trading at a level you’d expect to see from a junk bond rather than a bank.

Does this mean that Tier 1 financials are now the deal of the decade? I don’t think so. All Tier 1 bonds have a call option, whereby banks have the option to buy the bonds back at a set price on a given date in the future. Although this is an ‘option’ in the literal sense, the banks have previously stated that they will call these bonds (call dates are typically 10 years after issue).

But events of the past few months mean that it’s not actually in banks’ interest to retire existing debt and reissue it, because they will be losing money in the process. Banks will still try to do everything possible to call Tier 1 bonds because the reputational risk will be extremely damaging if they turn around and show two fingers to the markets, but Northern Rock’s experience suggests that some banks may not be able to afford to refinance these bonds. And if one large bank elects not to call Tier 1 bonds, and is not punished excessively by the market, then other banks could well follow suit. Bonds that were previously thought to have maturities in 5 or 10 years could suddenly become undated, which greatly increases the risk of holding them.

The problems don’t stop there. Have a look at the chart on Northern Rock’s capital structure (which is from June, before the BofE lifeline). At the top of the capital structure sit investors in senior secured paper, who are the first in line to get paid if the company runs into trouble. Equity investors sit at the very bottom. If Northern Rock’s position deteriorates further, the bank could first of all stop paying dividends to its equity investors. After that it is allowed to stop paying dividends to preference share holders. If it stops paying dividends to pref holders, it can then renege on its interest payments to Tier 1 bond holders.

So Tier 1 bonds, which were seen as a one way bet a couple of years ago (0.8% premium for bank bonds? Fantastic!) could suddenly go from being low risk, highly rated bonds with just 5 years to maturity, to being perpetual bonds with no maturity that don’t pay any interest. Is a 2.36% premium over government bonds enough to compensate me for this not-insignificant risk? Not in my opinion.

As an aside, it’s interesting to note that debt and deposits combined form £107.7bn of Northern Rock’s capital structure, while equity makes up £1.9bn, just 1.7% of the total, as at the end of June. Some people might understandably find equities more exciting, but as the recent credit crunch has demonstrated, the importance of what goes on in the bond and money markets cannot be understated.

 

Alongside Greenspan’s book, here’s something else that I don’t want for Christmas. Pre-order now at Toys R Us. Click image to enlarge.

 

Greenspan’s interview in today’s Daily Telegraph can be read here. It’s pretty bearish on the problems in the financial markets (and he thinks the problems will be greater in the UK than in the US, thanks to the number of variable rate loans), and also on the prospects for long term inflation, which could stabilise around 5%. Putting aside the issue of who created many of the problems in the first place, and we’ve pointed the finger in his direction several times before on these pages, he could well be right on both counts. Ambrose Evans-Pritchard, in an adjacent column to this interview in the print edition of today’s Telegraph, does an excellent job of dismantling the Greenspan myth. He quotes from Greenspan’s 1966 paper Gold and Economic Freedom: “The excess credit which the Fed pumped into the economy spilled over into the stock market, triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in breaking the boom. But it was too late: by 1929 the speculative imbalances had become overwhelming.”

Former MPC member Willem Buiter has laid into the bail out of Northern Rock by the Bank of England, just a couple of days after it talked tough about the importance of not supporting lenders who made risky decisions.

“Following the bail out of Northern Rock, I can only conclude that the Bank of England is a paper tiger. It talks the ‘no bail out’ talk, but it does not walk the talk. It does not matter whether the decision to bail out Northern Rock was initiated and/or actively supported by the Bank, or whether the Bank was bullied into it by the Treasury and the FSA. Moral hazard has received a boost in the UK banking sector and in the UK financial system as a whole. We will all pay the price in the years to come, when the next wave of reckless lending washes over us.”

You can read his full (lengthy and technical) comments here on his blog. Thanks to Citywire for initially highlighting them.

I am told that 75% of City traders hadn’t even started in the world of work at the time of the LTCM crisis (less than ten years ago in 1998). I don’t know if this is true or not, but it does put this (real, and not said ironically) quote from the senior swaps trader at a top 5 investment bank into perspective:

“In the 3 1/2 years I’ve been trading these markets, I’ve never seen it so bad”.

Ho hum. Elsewhere, it appears the US mortgage market is not completely closed for business, and a few other lenders could probably take some marketing lessons from Ric Flair Finance.

 

The Council of Mortgage Lenders has released this chart on the left. It shows that UK mortgage payments as a percentage of income is steadily rising, and now stands at nearly 17%, the highest it’s been since Q3 1992. However, this is still a way away from the peak of over 25% towards the end of the 1980s, just ahead of the property crash and recession. As we’ve noted though, with 2 million fixed rate mortgages refixing at higher levels in coming months, we are likely to see this "pain-o-meter" tick up.

 

Here is a link to our Credit Crisis teleconference replay. It’s approximately 20 minutes long, with slides, and there’s a further 10 minutes of Q&A afterwards. We cover the problems in the global money markets, the falling US housing market, and the prospects for corporate bonds and high yield if there is a recession or significant global slowdown.

Here’s a bit of proof of our assertion that the bond market is better at forecasting recessions than the Wall Street economists. Apparently in March 2001, the first month of the last US recession, 95% of US economists were predicting that there wouldn’t be one, and the average forecast growth rates for Q2 and Q3 were 2.2% and 2.3%. This New York Times article suggests that because recessions are relatively rare "it’s like asking people who spend their time in Alaska to start forecasting tropical storms". I prefer Merrill Lynch’s chief economist David Rosenberg’s comment in today’s FT when he states that telling a client that there’s going to be a recession "is like looking a client in the eye and telling them that their child is ugly. It’s not what people want to hear". For the record, Rosenberg, along with Richard Iley of BNP Paribas have been rare contrarians for the last year or so, and have been predicting tough times ahead.

Those of you listening in to our Credit Crisis conference call on Friday will have heard me suggest that the unemployment numbers would have to catch up with our expectations of an already softening American economy. We didn’t expect it to be such a rapid turnaround. Payrolls shrank by 4000 jobs in August, and back revisions meant that the economy has 200,000 fewer workers than the market expected. The "R" word is coming out thick and fast now. We will be putting link to the conference call on this site tomorrow if you missed it first time round – for those who did listen in, thanks, and apologies for the web freezing in the last minute of the Q&A. The World Wide Web is designed only to cope with the aftermath of a nuclear strike, not a fully blown credit crisis.

We’ve mentioned the crystal ball-like qualities of the US yield curve a couple of times on this blog. In May Jim showed that it can be a good predictor of recession (read article here), and the San Francisco Fed has recently published this interesting piece that adds weight to the argument.

There is some statistical analysis within the article, but in short it concludes that the yield curve is a better predictor of recessions than the professionals. There’s the old joke about the bond market predicting 9 out of the last 5 recessions – but the fact is that the economists employed by the investment banks predicted none of them. Nobody on Wall Street likes a bearer of bad tidings – just unleash the Rally Monkey and everything might be alright.

 

Month: September 2007

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