28 January 2009

UK versus US ~Prudent Bear Fund

The U.K. is in trouble. Today it was reported that the British economy contracted a much worst-than-expected 1.5% during the fourth quarter (not annualized!), the steepest economic decline since the dark days of 1980. Manufacturing activity sank a dismal 4.6%, while services contracted by 1%. Some forecasts now have the British economy this year suffering the most severe economic contraction since 1946. There’s now a strong case for using “depression” when describing this deepening financial and economic malaise.

The pound today traded at the lowest level against the dollar since 1985. This currency has depreciated 30% against the dollar over the past 12 months. Against the yen, the pound has collapsed 42% during the past a year. There is little room left for conventional monetary policy. At 1.50%, the Bank of England’s (BofE) base lending rate is today at the lowest level since 1694.

Curiously, the British pound has declined 6.5% against the dollar so far this month, while the dollar index has gained about 6%. I say “curiously,” as I would argue that in key aspects of financial and economic structuring, the U.K. provides a microcosm of our own systemic vulnerabilities. In a recent Bloomberg interview, Jim Rogers stated “The pound sterling is going to be under pressure. The U.K hasn’t got much to sell the world anymore.” His comments to the Financial Times were even harsher: “I don’t think there is a sound U.K. bank now, at least, if there is one I don’t know about it… The City of London is finished, the financial centre of the world is moving east. All the money is in Asia. Why would it go back to the west? You don’t need London.”

Following our direction, the U.K. over the past decade gutted their already shrunken manufacturing base as it shifted headlong into “services” and finance. While this finance and asset inflation-driven Bubble economy seemed to work miraculously during the boom, the post-Bubble reality is a severely impaired financial system and an economic structure incapable of sufficient real wealth creation.

I feel for British policymakers. Just five short quarters ago, overheated nominal GDP was expanding at about a 6% pace. And with inflation surging to the 5% level, the Bank of England pushed its base lending rate to 5.75% (summer of ’07). I’ll give the BofE Credit for trying to tighten financial conditions. It was, however, in vain, as Acute Global Monetary Disorder overwhelmed domestic policymaking. BofE tightening only widened interest-rate differentials, especially compared to near zero borrowing rates in Japan. Finance inundated the City of London in a finale of unwieldy speculative excess, setting the stage for a reversal of flows, de-leveraging and today’s collapse.

Yesterday, U.S. insurance company Aflac dropped 37% on concerns for its exposure to European “hybrid” securities - in particular preferred-type instruments issued by the large U.K. banks. According to research by Morgan Stanley (Nigel Dally), “When it comes to capital adequacy and investment portfolio strength, Aflac has historically been viewed as the gold standard across the industry.” Accordingly, the Street responded violently to the report highlighting the company’s potentially significant exposure to securities that have suffered huge losses in market value (Aflac rallied sharply today). According to the Morgan Stanley report, some of the hybrid securities issued by U.K. lenders Royal Bank of Scotland (RBS), HBOS, and Barclays are now trading at between 15 and 45 cents on the dollar.

Not long ago during the boom’s heyday, these types of securities were viewed as low risk instruments. They were, after all, issued by major – and at the time well-capitalized –banking institutions. In the worst-case scenario, these institutions (and their hybrid securities) were viewed as too big to fail. In reality, these banks were issuing a most dangerous class of securities - higher yielding (“money-like”) instruments appealing to even the more conservative investors. Today, the entire U.K. banking system is enveloped in a vicious downward spiral. Tens of billions of securities that only a short time ago were perceived as safe are being heavily discounted for the possibility the issuing institution will be “nationalized.”

On Wednesday, troubled Royal Bank of Scotland promised to lend $8.7bn in exchange for various lines of government support. The market took the news as a huge leap toward nationalization and governmental control over the U.K. banking sector. Even RBS’s CEO was quoted as saying, “We’ll be one the first guinea pigs.” The markets now view that U.K. policymakers will have few available options other than borrowing hundreds of billions to recapitalize their banks and support the securities markets.

Ten-year government “gilt” yields spiked 29 basis points higher this week to 3.68%, with a 2-wk gain of 55 bps. On Tuesday, Britain reported a $20.5bn (14.9bn pounds) fiscal deficit for the month of December. Spending was up 6%, while tax receipts were down 5.5%. The European Commission is now forecasting the U.K. deficit to surpass 8% of GDP this year. After trading at about 20 bps this past June, the cost of U.K. Credit default swap protection has spiked to 147 bps (traded as high as 165bps Wednesday).

The U.K. gilt market seemed to lead global bond rates higher this week. As the scope of global financial sector capital shortfalls and forthcoming economic stimulus become clearer, bond market nervousness grows. U.S. 10-year yields ended the week 31 bps higher at 2.59%, about 110 bps below comparable gilts. There should be little doubt that our new Administration will move quickly and decisively to try to bolster the financial sector and stabilize the real economy.

I fully expect our Post-Bubble Financial and Economic Predicament to parallel that of Britain. At some point, our problems will likely be of much greater scope due to, among other things, our system’s larger size. So far, the U.K. has suffered a more acute crisis due to its inability to stabilize its troubled financial sector. For one, it is suffering through a more destabilizing outflow of speculative finance (unwind of carry trades). Also, the U.K. financial structure has traditionally been less government-influenced – leaving it today more vulnerable to a crisis of confidence. Outside of government debt instruments, confidence has faltered for large cross-sections of U.K.’s financial claims (“moneyness” has been lost).

Our system has to this point proved relatively more stable due primarily, I believe, to the instrumental role played by government and quasi-government institutions such as the FHA, Fannie, Freddie and the Federal Home Loan Banks. The market’s perception of “moneyness” is retained for multi-Trillions of U.S. claims – a dynamic that bolsters the view that the U.S. dollar retains its “reserve currency” and safe-haven status. And as long as this confidence holds, faith in the government’s capacity for system “reflation” endures. But it all has the look of a fragile confidence game, and I fully expect the invaluable attribute of “moneyness” to be tested at some point.

There is absolutely no doubt that a massive inflation of U.S. financial claims is in the offing. One would suspect it is only a matter of when market perceptions of “moneyness” adjust. This week’s jump in gilt yields could portend a troubling new phase in the U.K. financial crisis. It could also be a harbinger of a more general crisis of confidence for global currencies and debt markets. The long-bond suffered its worst week since 1987 (according to Bloomberg). Gold was up $43 today and $56 for the week.


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