Cheap markets?
October 4th, 2011
Most western governments are running out of money. Few wish to rein in their appetite for spending to any great extent. The markets are kicking up a fuss about the large debts and growing deficits. It is at its most acute in the Eurozone. It is a problem elsewhere as well.
In the US, where one dollar in every three spent by the Federal administration is borrowed, they simply print more to keep the system going. They have had two bouts of quantitative easing, and are edging toward further monetary experimentation. In the UK, where the government borrows one pound in four it spends, there has been one big round of money printing, with the authorities looking as if they are ready to do it again. These policies have kept US and UK government bond rates low, assisted by the Central Banks keeping short term official interest rates on the floor.
In Greece, Portugal and Ireland where they cannot print extra money to pay the bills, the governments have been pushed into special loan arrangements with the IMF and EU. The Greek loan has become a monthly pantomime. Greece does not hit the targets for reducing borrowing, so each month pressure is applied to her to do better before releasing the lifeline cash which allows the Greek state to pay the bills. The markets think Greece will default, as the debt burden is great.
In Italy the government needs to roll over or refinance large sums because it has a very high historic debt level which it cannot afford to repay. Italy wants interest rates at 5% or lower. Markets want them higher. The European Central Bank has embarked on a large bond buying programme to try to keep the interest rates down by artificially inflating the prices of Italian bonds above the market level. This allows Italy to issue new ones at better prices and lower rates than would otherwise be the case. It is proving to be a very expensive programme for the ECB. Spain also needs help from the ECB in keeping her rates down.
In several countries including France leading commercial banks have lent large sums of money to the weaker governments of western Europe. If these bonds had to be marked to market, to reflect the low prices now prevailing, the banks would need to write off substantial sums and reveal weaker balance sheets. Fears of this has led to banks in the US and the EU being reluctant to lend to other banks for fear of their weak position. The ECB is now having to lend money to the banks on a large scale, to replace the money the market is no longer willing to advance.
All this is bad news for western markets. They rally on stories of large injections of Central bank cash. They fall on stories of bank losses, of bond market pressures, on fears of Greek bankruptcy and worries that the Greek loan will not be paid in full owing to poor performance. The system is highly stretched and is being kept going by Central bank action. The politicians of the EU are finding it difficult to agree and implement longer term loan arrangements for the weaker countries.
The end game could come anytime. It could entail a massive loan and printing operation to create and lend enough money to all the weaker countries. It could entail selective national bankruptcies within the Eurozone. It could end with the markets forcing countries out of the system. Two of these outcomes run the risk of bank disasters and a further liquidity squeeze on markets and banks. Meanwhile policy in the US and UK is inflationary, and Euroland policy could become so. We recommend continuing caution about risk markets. Investment should be confined to cash and near cash, and to good quality inflation hedges. This crisis is still hotting up, and the authorities do not have a working answer.
As published in Investment Week
