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Towards a painful climax

Towards a painful climax
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First Published: Mon, Jan 28 2008. 11 32 PM IST
Updated: Mon, Jan 28 2008. 11 32 PM IST
If you are a believer, then you could feel proud about the way your god is playing dice with financial markets. Not only does God have a sense of humour, but he (or she) appears to be a good story teller, too.
An exaggerated swoon in global stock markets forces the US Federal Reserve to fire precious interest rate bullets. Then, it is revealed that a rogue trader in a French bank had run up losses amounting to more than $7 billion. The Bank of France knew about it, but it did not inform the Federal Reserve. The Federal Reserve is said to be unhappy that it reacted to the stock market swoon that was amplified by the French bank cleaning up its trader’s positions.
As a result, 75 basis points of the federal funds rate have been too easily used up.
In spite of this, the market expects the Federal Reserve to cut interest rates again on Wednesday. If the Fed does not, the market would swoon once again, underscoring the Fed’s poor judgement in cutting rates last week. If it does, then it would have injected far too much monetary stimulus into the economy than it intended. The price of crude oil is back above $90 per barrel.
Unquestionably, this is a fascinating script. The climax is bound to be thrilling, but it is not guaranteed to be pleasant. In fact, the opposite is more likely.
The slide in the global stock markets in the first two days of last week was matched by the dramatic recovery over the next two days. The ostensible reason for the recovery was that the New York insurance regulator had organized a meeting to discuss recapitalization of companies that insured bonds. Without insurance and the guarantee of payment when the issuer defaults, most of the debt instruments issued would lose their rating and hence their values would plummet. But, a solution is far from easy. Recapitalization is costly (some estimate it at $200 billion) and comes at a time when banks themselves are still raising capital to strengthen their balance sheets.
Crucially, neither the banks nor we know the extent of additional capital that they need. It depends on the extent of the likely further drop in American home prices. Merrill Lynch expects the cumulative decline to be around 30%. If so, the rout had just begun as the decline, as per the Case-Shiller national home price index in the US, is only around 6% so far.
Nonetheless, the message from the market action this week is clear. Equities were dropping even after the Fed cut rates. Only talk of recapitalization of the bond insurers helped to turn sentiment around.
Do not throw lower rates at the problem. Lower rates created it. There are only two solutions. Both are neither quick nor painless.
One is that banks have to assess all their current and potential losses and recapitalize themselves. The second solution is that prices of financial assets have to fall far and deep to draw investors back to the market. The process is under way in some asset classes, but barely in the case of equities. The big rebound in equities markets after every correction suggests that noise traders are dominating it. They prevent the market from forming a credible bottom and thus keep informed investors out of it.
Unfortunately, the Federal Reserve encourages such behaviour. By cutting rates in response to falling stock markets, it is not only delaying the inevitable in the US, but is also stoking asset price bubbles and consumer price inflation in developing countries. Core inflation was the highest in 16 years in Australia in the fourth quarter of 2007. Officially reported inflation in Singapore moved up to 4.5% in December.
Investors should watch for signs that central banks in Asia are alive to this threat. If they counteract the wall of liquidity flooding in from the US, then they would be doing the right thing by their economies. India has done that. Even there, a test is looming.
Pressure from politicians and industry to cut rates is mounting as the Reserve Bank of India (RBI) announces its policy review today. If RBI holds its nerve, Indian equities would deserve a higher market valuation for that reason alone.
Those who suggest that RBI should lower rates want to have their cake and eat it, too. On the one hand, they boast that the strength of the domestic demand in India would not allow America’s problems to derail India’s economic momentum. On the other hand, they want RBI to lower rates because the Federal Reserve has done so.
The gods are setting up policymakers to commit more errors on top of all that they had done up to now.
So, if you are a believer and an investor, the message is clear: Run for safety.
And safety lies in precious metals and cash under the mattress.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore. These are his personal views and do not represent those of his employer. Your comments are welcome at baretalk@livemint.com
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First Published: Mon, Jan 28 2008. 11 32 PM IST
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