Moving To An Ultra Low Interest Rate World
7 November 2008
The three major currencies in the world are the US dollar, the euro and the Japanese yen. The cost of borrowing in these currencies is extraordinarily low, and about to get much lower. The interest rate in the US is 1% and will likely head lower when the Fed next meets in mid-December. To be specific, the target rate is 1% but the Fed's effective funds rate is much lower. At last count the effective rate was just 0.23% so at this stage another 50 basis point but in December seems like a done deal.
Moving over the Europe, the hard money' men running the ECB have just lowered interest rates to 3.25%, with more cuts expected. And low growth, high saving Japan has an official borrowing rate of just 0.30%.
Looking at the other major currencies, the Bank of England just shocked markets with a massive and unprecedented 150 basis points to 3%, indicating their economy is in real trouble. Switzerland's interest rate was also reduced on Thursday by 50 basis points to 2%. Canada's official rate sits at 2.25%, Sweden's 4.25% and Norway's 5.25%. Recent moves in these countries have all been down and the bias remains for lower official rates.
In the Asia Pacific Region, Australia's official interest rate was reduced by a more than expected 75 basis points on Tuesday to 5.25%; New Zealand is at 6.50%, China, now on an easing path, has a rate of 6.66%, while Hong Kong and Singapore, with strong links to US trade, have similarly low rates of 1.50% and 1.24% respectively.
In short, the major developed financial centres of the world are all lowering the cost of credit. It remains to be seen how effective this policy will be, given large numbers of these countries' population already have too much debt. However, the resulting lowering of debt servicing costs will take some pressure off the consumer.
Combined with expansionary fiscal policy (they're all Keynesian's now!) global policy makers really are throwing everything at the economy. A recent press release from the US Treasury indicated the US government's borrowing requirement for the three months to December will be $550 billion, an amount that includes $260 billion for the Supplementary Financing Program (SFP), which we'll explain in a moment. This comes on top of a $530 billion borrowing binge in the prior quarter, which included $300 billion in SFP borrowing.
The SFP was established in September when it become clear the Fed had much more bailing out to do. All the Fed's lending facilities, which hold dodgy mortgage debt or short term commercial paper, need to be purchased with something. As the Fed's own stash of Treasury securities was dwindling, the Treasury issued more paper onto the market and gave the cash to the Fed, who on-lent it to the US banking system.
Looking at the Fed's balance sheet, you'll see a massive increase in assets and liabilities over the past year (which reflects the huge expansion of Fed credit). The quality on the asset side looks poor, while the growth in liabilities is essentially US Treasury's, with the SFP approaching $600 billion.
We're not sure how long the Fed can continue borrowing from the Treasury like this. At 50 times, the leverage in its balance sheet is enormous (meaning $1 of capital supports $50 in asset value). But as the Fed is not a commercial bank, such leverage is probably not an issue.
With the balance sheet so stretched, one would think the Fed would be squeezing as much as they can from their assets. Not so. The Fed and Treasury continue to value their 261.5 million ounces of gold holdings at $42.2222 an ounce, providing the Fed with a balance sheet value of just $11 billion.
At today's price of around $730, the Fed's assets would rise by $180 billion, or roughly the amount Fed credit expanded last week. But a glance at the Treasury's US International Reserve Position' tells us why a gold revaluation will not occur anytime soon. According to the Treasury, their description of gold is as follows:
Gold (including gold deposits and, if appropriate, gold swapped).
Interestingly, the additional explanation that the country's gold stock includes swapped gold only began appearing from 14 May, 2007 onwards. It would appear that the US Treasury and Fed do not hold anywhere near the amount of gold they claim to, with the mysterious difference representing a short position in the gold market.
We continue to monitor the bond market for clues as to investor appetite for US Treasury's. As shown in the chart below, the US ten-year bond yield hit a low in mid-September. In other words, bond prices looked like they peaked in September and even in the panic of October could not make new highs.
The government bond market bubble, based on unquestioned faith in US government credit, is perhaps in the initial stages of deflating. The big question is where does the money leaving the bond market flow to? We're likely to find out in the next few months, but our guess is that the gold and silver markets will provide accommodating homes.
Looking at the chart below, we see gold continuing to correct the nine year advance from the 1999 lows to the all-time high of $1032.70 reached earlier this year. Although holding above the 24 October low of $682.41, rebound attempts have been capped by resistance in the region of $775 to $780.
In the near-term, we anticipate further consolidation below $780. While this barrier continues to cap prices, we cannot rule out a deeper correction to levels below $682.41.
Despite the near-term correction in gold, the longer-term outlook for the precious metal remains positive. In our opinion, a clear break above $780 will improve near-term momentum although a further break above the $850 region is required to signal a restoration of the longer-term upward trend.
While the bond market looks to be getting restless, the inflation/deflation camp remains evenly split. The asset market deflation we have witnessed over the past 12 months is flowing through to the real economy, so shorter term, deflationary forces have the upper hand.
Deflation usually occurs when too much debt in the system directs the economy's income into debt servicing and repayment. This detracts from discretionary spending causing a slowdown in consumption, which in western economies generates around 70% of economic growth.
The resultant slowdown in economic growth causes an increase in unemployment, which in turn impacts the ability to service debt, leading to an increase in bad loans and a weaker banking system (sound familiar?). Unchecked, the negative feedback loop compounds and the deflation becomes embedded, until the debt load is purged from the system.
While this is the free market way of a system correcting imbalances, we do not exist in a free market. Huge government intervention, in the form of monetary and fiscal stimulus, has been aimed at slowing the correction down, and eventually reversing it.
High private sector debt levels are effectively being transferred to the public sector. Inflation will begin to surface when there is not enough demand for all the government paper, and governments need to print (create) money to enable the ongoing issuance of debt. That situation is not upon us yet, but if history is any guide, it will be soon enough.
Moving on to the credit markets, the thaw that began a few weeks ago has continued, albeit slowly. While still very high by historical standards, the extreme fear we saw in October looks to be receding, as illustrated by the VIX index. However the process is a slow one and the VIX has spiked again in recent days.
The TED spread (the difference between 3 month LIBOR and 3 month US Treasury's) has also declined in recent weeks, although it still remains elevated. This suggests that concerns remain about who is solvent and who is not. The latest data from the Fed shows banks continuing to deposit excess funds at their reserve banks rather than lend it out. This is something the authorities will be concerned about.
As is evident from recent trading, much uncertainty still exists with respect to the outlook for the economy and markets. The falls we have witnessed over September and October priced much of the bad news into equities and investors are currently grappling with the question, has enough bad news been priced in? We can't say for sure, but it is evident that the market is trying to find a bottom at these levels.
From a technical perspective, the S&P500 has entered a period of consolidation, between support at 839 and resistance in the region of 1007 to 1044. As evident on the chart, this follows an accelerated decline, which saw the index decline by as much as 35% in just six weeks.
In our opinion, further consolidation within the noted range is likely in the weeks ahead. However, considering the direction of the broader trend, while ever the index remains below resistance, we cannot rule out a continuation to new lows. In saying that, a break above 1044 would greatly improve the near term outlook.
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