Croesus/ The Investor's View:The closely watched US employment report released last Friday revealed a drop of 4,000 in US employment which shocked the markets. A sharp sell-off in the US stock market was predictably followed by falls in Europe and the Far East.
Although the monthly data is often revised, and one month's data only tells a small part of the story, the release was sufficient to bring to the surface widespread nascent fears that current financial market turmoil may eventually lead to an economic recession. So far, the housing slump in the US has not damaged consumer confidence. However, if house price declines were accompanied by rising unemployment, the risks of a slowdown in consumer spending would be considerable.
To date, the US economy has continued to perform well. However, the failure of the housing market to stabilise presents a major challenge. Recent data confirm that house prices across the US continue to fall and financial market turmoil is likely to intensify the housing downturn.
Furthermore, many US borrowers who took out adjustable rate mortgages at low introductory rates in recent years will be facing sharp rises in mortgage costs in the coming 12 months.
This is something that is also expected to be a negative for the British housing market where a large number of borrowers will be coming to the end of cheaper fixed-rate terms in 2008.
Central banks in the US and Europe are alive to these risks and have been quick to intervene in the financial markets. Policymakers have two key roles to play, the first of which is their role in setting short-term interest rates. The actions of central banks in this regard receive an enormous amount of media attention. This reflects the fact that any change in official rates is rapidly reflected in retail deposit and lending rates.
The tendency of central banks in recent years to engage in a series of incremental interest rate changes has served to further heighten their public profile. An example of this is the European Central Bank's policy of engaging in regular incremental interest rate rises. Media attention is further intensified by the predilection of central bankers to use opaque language and key phrases to signal any upcoming changes in policy.
The second key role of central banks is one that generally receives very little public attention. Most of the time this role is routine and involves ensuring that the financial system functions smoothly. Interventions are largely technical and involve central banks lending to the market when there is a shortage of funds, and absorbing funds from the market when there is excess liquidity. The fact that so little is heard about this role is testament to how well the capital markets generally function.
Developments in recent months have dramatically altered and it is now clear that, without swift central bank interventions, the money markets could have seized up over the summer. Heightened fears regarding the credit quality of securitised assets has created a scenario where banks have become slow to lend to each other. This has manifested itself in money market interest rates that are much higher than official rates. Interest rates on three-month money are 5.7 per cent, 4.75 per cent and 6.9 per cent for the dollar, euro and sterling respectively.
Although the current financial markets turmoil has not yet had any impact on the real economy, the longer uncertainty and turbulence persists, the greater the risk that the real economy will eventually suffer.
To understand why the current financial markets crisis is so difficult to manage involves appreciating how the banking system has evolved over the decades. Today banks hold a much smaller proportion of their assets in the form of liquid assets. Historically, British and Irish banks typically held up to 30 per cent of their assets in the form of cash or highly liquid and default-free treasury bills in the UK and exchequer bills in Ireland issued by government. With this balance sheet, the chance of any of the big clearing banks becoming short of liquidity was very low.
The drawback from the banks' viewpoint was that cash and short-term bills are very unprofitable. Therefore, as the capital markets became more sophisticated, banks sharply reduced the proportion of their assets held in liquid form. For the UK banking sector at end June 2007, the proportion of assets held in cash and default-free short-term securities was under 2 per cent.
This shift over the years has made banks more profitable, but also more vulnerable in a crisis such as the current one.
Banks do have a buffer of liquidity in the form of sale and repurchase agreements with the central bank. Effectively, the central bank lends to the banking system on a collateralised basis. Banks must use high-quality government bonds as collateral, and cannot use other assets such as the newer asset-backed securities. In their quest for profit, banks now hold a much higher proportion of their assets in these hard to value and hard to trade securities.
Therefore, there is a limit in the capacity of central banks to add liquidity to the financial system.
Although we are in uncharted waters, Croesus takes the view that central banks will eventually succeed in navigating through the current turbulence. Unfortunately, there is no single short-term fix so that uncertainty and above average market volatility are set to persist for some time yet.
