No man is an island

It was the Goldman Sachs analysis this week that caught my eye. It highlighted recent lending activity across regions. No surprises then that banks across Europe have reined in cross border lending given: 1) the amount of regulation that they now have to contend with and 2) suspicions that the euro may implode in the future.

So unsurprisingly you have national supervisors compelling local banks to build up capital and liquidity at the expense of other EU countries. As one regulatory source has said:’As the crisis has deepened there has been a rationale for national regulators to make sure their own country is ok’. So a case of batten down the hatches then. Not great considering we are all part of the global market and what impacts in one country usually has a much wider knock-on effect internationally.

I suspect this comes down to confidence as banks in Northern Europe appear to be curbing their exposure to Mediterranean countries for fear that their loans will be repaid in reintroduced national currencies. Understandable but given we live in a globalised economy we cannot afford to take this unilateral ‘I’m alright Jack’ approach. There has to be a balance between regulatory controls and a common sense attitude to cross border lending. Otherwise the markets will grind to a halt and it could go horribly wrong for us all.

The Great House Price Conundrum

Is it house prices up? Or house prices down? Or house prices remain the same? Well I guess it depends on what survey you are looking at. The recent Nationwide House Price Survey supports that view that house prices have fallen again last month and are 2.6% lower than they were a year ago. However the Land Registry reports that house prices have risen slightly over the year albeit sales of £1m plus homes has dropped sharply. There certainly is a variance of views at the moment.

I think what it is fair to say is whatever analysis you are looking at is that the market is starting to stall somewhat. It is still early days with the new Funding for Lending scheme so it is unclear as to what good this will do. Early comments suggest that whilst it has been good for people with a large deposit to put down, it is less helpful to those customers on higher LTVs but maybe this will change over time.

So how important is maintaining a robust housing market for the economy? Hugely important. Not only does a healthy housing market deliver jobs in various sectors but owning your own home is still a huge aspiration for many people living in the UK. It is also a huge lever in instilling greater consumer confidence in the economy at large.

Whilst the IMF suggests there is a correction to be made and we still have a house price bubble in the UK, I tend to dispute this view. I think that demand will always outstrip supply (we can’t build enough houses to meet demand) so I don’t believe that house prices will crash anytime soon. However I predict house prices will remain at best stagnant for the rest of this year and the market needs as much support as possible to encourage lenders to provide funding across the board supporting all LTV groups. Let’s hope the Funding for Lending scheme does the job it was set up to do. 

Clouds on the horizon

Following the disappointment of UK GDP figures released this week registering a 0.7% drop, I was heartened to think that third quarter GDP will see an improvement. The bounce back in the third quarter will relate in part to the positive impact of the Olympics and the likelihood of an increase in private sector pay deals which will outstrip RPI inflation for the first time since 2009. So with more money in our pocket, that’s great news as the assumption is that we will spend more and drive the economy back into positive territory.

However trawling through economic news today I was disheartened by news from the US department for agriculture that has warned that food prices are likely to rise in the US next year due to a drought gripping large parts of the Midwest. It reported that this is the worst seen since 1956 and prices are expected to rise by between 3% and 4% in 2013. Corn and soybean price have already soared recently as fields dried out and crops withered.  Richard Volpe of the US department for agriculture told Reuters that ‘the drought is really going to hit food prices next year’ adding that the pressure on food prices would begin to build later this year.

So why should we be concerned? Well the US is the world’s largest exporter of corn, soybeans and wheat and a rise in prices will impact economies worldwide.

In June, UK food inflation fell to 3.5% from 4.3% - its lowest level in almost two years. However if the drought in the US doesn’t end, prices could once again rise. Colin O’Shea, head of commodities at Hermes Fund Managers said: ‘If we do not get rain in the near term then corn prices and related crops will continue at these elevated price levels. As a result the Governor of the Bank of England many not get the falling inflation numbers that he so desires’.

The last thing we need is for inflation to become a problem once again. Let’s pray for rain! In the US at least….

What now for the Brics?

Of all the recent economic statistics to come out, the numbers that concern me most are those coming out of a recent report from HSBC which suggests that growth is slowing in the four big Bric countries - Brazil, Russia, India and China. These have been some of the fastest growing economies of the past ten years, and have been largely responsible for keeping the global economy moving forward. Yet now they are facing a sustained slowdown which has largely been blamed on the euro crisis and deterioration in the US economy.

Let’s look at these two issues. Well sadly I predict that the euro crisis is set to run for some time. Even Sir Mervyn King seems despondent accusing EU leaders of failing to tackle the fundamental causes of the crisis and adopting a policy of ‘kicking a can down the road’. He suggests that ‘there is a great black cloud of uncertainty hanging over businesses’ and until they know how things are going to pan out, ‘they are holding back from investment and spending’. His comments seem to make sense albeit will do very little to instil confidence in the UK.

I think economic data from the US is a little more encouraging, after all statistics suggest that the US trade deficit narrowed in May with exports to Europe rising. Yet analysts have warned this may not last suggesting it is ‘unlikely to be sustained in the coming months’. I am however encouraged that the Federal Reserve will act to provide further stimulus if things get worse although I can’t see a rapid return to growth in the US.

So going back to the Brics. Of all the emerging economies, China in particular has responded rapidly to a slowdown with its government easing the curbs it imposed back in 2010 which at the time were brought in to cool an overheating economy and curb inflation. Beijing has cut interest rates twice since the start of June and announced various additional stimulus measures. These measures initially appeared to do some good but with external influences affecting demand for China’s commodities, forecasters have now put back prospects of a rebound until at the earliest later this year.  

I fear we will have to wait some time until the world’s second largest economy, along with other Brazil, Russia and India, once again drive global markets.

LIBOR and Barclays - the real world

If you look at the British Bankers Association website you will see that each contributing bank to the LIBOR rate setting has to answer the question: “At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?”

So BBA LIBOR is not necessarily based on actual transactions. This is an important point.

It seems to me that the latest scandal to hit the markets is little understood by most of the vociferous market spokesmen and commentators.

I am not condoning wrongdoing that Barclays have owned up to but we do need to get this in perspective. First of all LIBOR is not some mathematically computed number which is always accurate to within fractions of a basis point. It is a number derived by dealers in prime banks talking to each other having observed the yield curve and the latest supply and demand for money in the markets and for them at that moment. It is a matter of opinion.  

Even if Barclays were a sole outlier in the LIBOR rate setting, the effect would have been eradicated. Every BBA LIBOR rate is calculated using a trimmed arithmetic mean of all rates submitted to them. Once all rates are received the rates are then ranked in descending order and the highest and lowest 25% of submissions are excluded - this is the trimming process. 

Looking at the second of the two breaches by Barclays; that they rigged the LIBOR rates between September 2007 and May 2009 by making LIBOR submissions which took into account concerns over the negative media perception of Barclays’ LIBOR submissions.

In other words they were looking to mask any Barclays’ specific problems.

Well I well remember this time vividly and as someone who has operated in the sterling money markets since the 1970’s I can assure you that what was happening at that time was far from normal. We were seeing major banks worldwide finding difficulty with raising money in the markets to cover their liquidity positions. The first major warning sign of the credit crisis that I observed was a movement in 6 month LIBOR in excess of 65 basis points above Bank Rate and with no yield curve cause. In other words it wasn’t that banks thought that rates would rise, it was simply that banks were struggling to fund themselves and would pay “whatever it cost” to cover funding positions. Very scary! There were rumours abounding about ‘major banks being in difficulties’. In this market it must have been tricky for any bank to fix a normal LIBOR setting for the BBA. To signal that your bank had a worse position that others and therefore had a problem must have been a real cause for concern.

I could quite understand in fact why it may have been prudent to agree with the Bank of England that a ‘normalised’ LIBOR rate should have been quoted and to take out the peaks and troughs of a far from normal market. But this does not appear to have been the case based on Bob Diamond’s evidence yesterday. Let’s see what Paul Tucker has to say. I’m not trying to make excuses for others and certainly have no axe to grind with Barclays but in relation to the LIBOR fixings in extreme markets maybe we need to reflect on just what was happening in a very hostile real world.

Just as an afterthought however, Bob Diamond’s letter to Andrew Tyrie ahead of the meeting said “The interventions in question were typically on the short term one and three month rates relevant to the wholesale markets and not the longer term rates used to set, for example, retail mortgages.” What planet has Bob Diamond been on? Mortgage rates are set relevant to short dated LIBOR rates such as 1 month and 3 month and not 6 or 12 months.

Sorry but this just doesn’t add up! Get a grip Mr Diamond.

How Central Banks should work

I was heartened to hear Deputy Governor of the Bank of England, Paul Tucker’s words last week hinting that there needs to be a shift in approach as to how the British authorities deal with the lack of affordable credit being made available to British companies and households. Mr Tucker went so far as to say that recent regulation could be proving counter-productive and that banks should be ready to draw on their liquidity buffers rather than hoarding cash.

And then we had the George Osborne/Sir Mervyn King announcements of making funding and liquidity available to the banking sector last Thursday night.

This is a very significant change in policy for the Bank of England and should be noted.

It has been interesting to see how Central Banks have focussed their efforts in a continuing and volatile market situation: in the US the Federal Reserve Bank has extended its ‘Operation Twist’ – a scheme to lower long-term interest rates, which had initially been due to end this month.

It also confirmed its intention to keep short-term borrowing costs at ‘exceptionally low levels’ amid concerns over the US jobs market but they have stopped short of unleashing a third wave of money-printing, or QE3. They have also been active in purchasing debt instruments to ensure a strong supply of credit to the markets.

But the Bank of England has been more conservative and until now at least have eschewed the traditional role of the Central Bank which is to be a lender of last resort, particularly in times of financial distress. The widely accepted critical role of a Central Bank was defined by Walter Bagehot - a 19th century English intellectual who summarised the lender of last resort function with the dictum “lend freely at a high rate, on good collateral.” This has been an anathema to the Bank of England until now where the view has been that it is not to the role of the Bank of England to support the banks – that way leads to moral hazard and encourages loose lending and liquidity practices with the knowledge that the Bank of England will be there to pick up the pieces if it goes wrong.

But all that now appears to have changed.

With the broad supply of money contracting (cash and money in bank accounts), the money multiplier is no longer functioning. Add to that the tendency for banks to hoard cash and rebuild capital reserves and it’s no wonder that the economy has been grinding to a halt amid fears of another credit crunch. Add to this the Eurozone worries and it has been enough to create a major policy change for the Bank of England.

Thus far the Bank of England has been reluctant to take a revised course of action directly to ease banks’ funding costs, preferring to use their quantitative easing (QE) programme to improve liquidity. However it is apparent that banks have not using the facility as intended, choosing to stockpile the money in safe assets and deposits with the Bank of England rather than inject the money into the economy as intended.

It was time for a radical rethink and I’m pleased for the change in stance. Now is not the time for an excess of caution. The markets may be the best capitalised and have superb liquidity positions but if we are not careful the markets and economy will stagnate.

Now is the time for the Bank of England to act like a traditional Central Bank and be prepared to lend against good collateral. I’m delighted that it is doing so now even though it’s taken an awfully long time to get here.

The World as One

Over the last few days Barack Obama has joined the fray on the great eurozone debate and agreed with David Cameron that an ‘immediate plan’ was needed to stabilise the single currency and restore market confidence. He has spoken to Angela Merkel and Italian Prime Minister Mario Monti on the need to strengthen the eurozone. Some may say what business is it of his. I say good for him.

This is despite the regular ‘Beige Book’ survey of the US economy showing a rise in growth over the past two months. For those who wonder what the Beige Book is, it’s a survey that canvasses opinion from business across the US for the Federal Reserve eight times a year and is hugely important to the central bank in helping them set their monetary policy.

Some could argue that the US has limited exposure from fallout of the eurozone crisis. In fact David Cameron has reported that the British economy is six times more exposed to the eurozone than the US economy. True but then again the US isn’t completely untouched by what happens in Europe as there is a huge risk of contagion to key oversees American markets and a euro break up could have a devastating effect on the US exposure to trade with emerging markets, in particular China. So they are right to be concerned. Warren Buffet, billionaire investor and respected commentator has acknowledged that the chance of the US slipping back into recession are ‘very low’ unless the eurozone crisis escalates further with ‘events in Europe developing in some way that spills over here big time’.

So world leaders have a right to have their say. We must be prepared to accept that the global economy has changed significantly and they all have a part to play in helping to stabilise world markets. Individual states cannot afford to operate as a silo unit. 

Nor would we want them to…