What a wonderful world

“Sir, Before my fixed-term bond with London Scottish matured on November 21, I was invited to reinvest the proceeds for another year at 7.15%; an amazing and tempting offer in today’s markets.

 

“On due reflection I decided that, as with previous rates offered by Icelandic banks, it was “too good to be true” and did not proceed. How wrong I was. I understand that this investment, however large, will be honoured by the government.

 

“The moral must be to find the shakiest bank and invest in its most ridiculously high fixed-rate bond. No judgment or personal responsibility required, the taxpayer will take the strain.”

 

-       Letter to the Editor, Financial Times, December 4, 2008.

 

 

I see soup canteens, dole queues too

I see the boom all over for you

And I think to myself what a wonderful world.

 

I see flats unsold, old bomb sites,

Property investors receiving their last rites

And I think to myself what a wonderful world.

 

The colours of a mushroom cloud so ghastly in the sky

Are also on the faces of people going by

I see friends shake Guy Hands saying: what did you do ?

They’re really saying: we will sue.

 

I hear babies cry, I watch them grow

They’ll owe much more than I’ll ever owe

And I think to myself what a wonderful world.

 

(with apologies to Bob Thiele, George David Weiss and Louis Armstrong.)

 

--

 

So there we have it. Whether it was the rest of us, or just the news media, we have ended up talking ourselves into recession. Indeed the US National Bureau of Economic Research announced last week that economic activity peaked – and that recession therefore began in the US – as early as December last year. Their ‘Business Cycle Dating Committee’ reports that it views “the payroll employment measure, which is based on a large survey of employers, as the most reliable comprehensive estimate of employment. This series reached a peak in December 2007 and has declined every month since then.”

 

And Richard Lambert, director general of the CBI and former editor of the Financial Times, went on to suggest that journalists had spread unsubstantiated rumours about troubled financial institutions and that the Press Complaints Commission should have issued guidance to business journalists on the importance of accurate information amid a crisis. But,

 

“Instead, there had been stories that had alarmed savers with melodramatic language, unsourced quotes and suggestions that problems in one institution were spreading to others.”

 

Perhaps the likes of Robert Peston should always be allowed to salivate energetically, and in his case oscillate vocally, over the failure of the latest financial institution – even when briefed selectively by unpublished, price-sensitive sources whose first responsibility should be to the Stock Exchange. But nobody could accuse the (financial) media of even-handed coverage of the financial crisis, nor of the recession / depression that now follows in its wake.

 

But we are where we are. Now that UK base rates are back down to levels last seen during the Festival of Britain, it is becoming increasingly difficult to shelter in cash, as the government’s War on Savers moves into full throttle. Gilt yields, similarly, are starting to look eye-wateringly slender; but they could easily become even flimsier. As James Ferguson, Chief Strategist at Pali International, has observed:

 

“..all things are not equal.. the experience of systemic banking crises and their attendant recessions suggest that bond demand, from both non-bank investors but especially from the banks, could explode beyond anything seen for decades, completely swamping new supply. Meanwhile, the banks’ de-risking of assets will pump powerful deflationary pressures into the real economy.”

The idea that banks could comfortably absorb the colossal supply of “new” Gilts is, at first sight, somewhat counter-intuitive – but James makes a convincing case for Gilt bulls. Increased demand for UK government debt will likely come from two specific areas:

 

“First, a normal rebalancing of portfolio preferences in favour of a heavier weighting in government bonds, as is quite usual in recessions and at other times of increased investor liquidity preference.

 

“Second, and less obvious, it is a feature of systemic banking crises that banks, once recapitalised by state funds and whilst working to shrink their risk assets, concentrate their efforts particularly on de-risking the profile of their remaining assets.”

 

It is certainly becoming acutely obvious that banks remain unwilling to lend, both to individuals and to corporations. Instead, they may simply elect to park capital in the Gilt market and earn the essentially riskless spread of longer dated Gilt yields over shorter ones. And as James points out, the potential for banks to absorb Gilt supply is startling:

 

“..a big bank like, say, RBS could potentially soak up this massive excess supply all on its own. RBS has £1.95trn in total assets, of which £728bn is loans.. If we take a muted version of the Indonesian [banking crisis] scenario, within five years it’s possible that loans could shrink 20% to £585bn (30% of assets) whilst if Gilt holdings increased to just 15% of total assets (they reached 45% in Indonesia), that would imply demand of £300bn, just from RBS alone: enough to soak up our assumed five-year excess supply of Gilts in its entirety.”

 

Basing an investment thesis on presumptions, albeit well-founded ones, of future buying by third parties is obviously somewhat fraught. Investors seeking quasi-cash alternatives and considering Gilts can comfort themselves that in Japan, a major economy that underwent a property and banking crisis throughout the 1990s, government bond yields fell further than the wildest expectations of the most expectant bulls: 10 year Japanese Government bonds ended up in 2003 yielding just 0.44%.

 

The world, of course, is not necessarily like Japan. We must at least hope not. But it certainly looks less than wonderful at present. An already astonishing investment environment can be counted upon to throw a few more surprises our way.

Comments

[Tradebot]

Uh huh. I kinda consider James Ferguson as contradictory indicator and he has not let me down this time either. Funny how equity guys always get confused by fixed income... it must be the big numbers. The whole idea of banks buying Gilts is just plain rubbish : banks are all deleveraging and getting rid of RWAs as fast as they can. It is a question of funding requirement = less the better. If you look at the subscription rates to BoE funding + Libor / OIS spreads you can see the premium paid for cash...

[timprice]

We evidently know different James Fergusons. The James Ferguson I know has consistently (for at least the last 18 months) talked about the damage to be inflicted upon banks and the likely effect upon the government bond markets. As a strategist / economist he may well not take kindly to being described as an "equity guy". As to banks buying Gilts - not that the FSA has been ahead of the curve, but see FT p. 21 today for some anecdotal evidence of regulatory pressure to buy Gilts, quite alone from the economic pressure, which is likely to prove more influential.

[timprice]

p.s. James can fight his own battles, but the Gilts call - thus far - has been bang on the money, despite the critics (among them myself, for a period) who have agonized about the potential impact of all that supply. How exactly has JF been a contrary indicator ?

[Tradebot]

http://jobsinthemoney.info/file/219/james-ferguson-.html

Not that there is anything bad to spend a career in equities.

Well, regarding the Great Gilt rally in 2009 - we shall see. It takes two people to make the market and Gilts at below 3.5% are "yours". Lousy yield, lousy currency.

[Tradebot]

well, being a stockbroker is very different to running a bond fund. I'll take my cue from PIMCO rather. No disrespect.

but the whole idea that bank like RBS would "soak" the whole excess supply is rubbish. If you haven't noticed the banks are shrinking their balance sheets - not increasing them. ie. my point about funding issues.

Hence your domestic investor base to soak up supply (both private and public sector issuance) is extremely limited. The buyers need to come from somewhere else and as international bond fund manager why would i want to overweight Gilts at yields lower or close to Eurozone? Difficult to fund, currency hedging is expensive, huge amount of downside risk as supply explodes... no thanks.