Don't Blame The Free Market
By Colin Twiggs
March 27, 2008 2:00 a.m. ET (6:00 p.m. AET)
Financial Times features an article pronouncing the end of
a three decade move towards market-driven financial systems and
quotes Joseph Ackermann as saying: "I no longer believe in the
market's self-healing power". The Deutsche Bank CEO appears to
have forgotten that financial markets are the exact opposite of
a free market. Instead of allowing the market to establish its
own equilibrium rate of interest, matching supply of credit
with demand, the Fed and other central banks impose artificial
rates for political ends.
The current financial crisis was wrought by the Fed imposing just such an artificially low rate. The resulting mis-match between supply of credit and demand encouraged poor lending practices and fuelled a housing bubble of epic proportions. Financial markets require greater policing, but precisely because they are not free — and there is no market mechanism to prevent the resulting excesses.
The seriousness of the housing bubble is best illustrated by the ratio of the S&P Case-Shiller Composite Housing Index to Disposable Income per capita (before adjustment for inflation). The previous high of 0.45% in the late 1980s was dwarfed by the reading of close to 0.6% in 2005/2006. There has since been a strong retracement, but the index remains well above the 0.4% level needed to motivate home-buyers.
real estate exposure exceeding $7 trillion and total
capital and reserves of just under $1 trillion, a further 10%
fall in house prices would have a devastating effect on the
banking system. Much of their normal margin of safety has
already been wiped out by the existing fall. While this may
appear an extreme scenario, the economy faces falling
consumer sentiment and declining incomes from an
I am sure that the problem has been keeping Ben Bernanke awake at nights. With interest rates already close to record lows, the only tool the Fed has left in its toolbox is inflation. By raising nominal incomes rather than lowering house prices they can achieve the same end — but at what long-term cost to the economy?
The spread between the fed funds rate and 3-month T-bills remains above 1.0%, warning of an unstable market — where investors prefer the safety of treasury securities against higher yields in the inter-bank and commercial paper markets.
The 1998 LTCM collapse, by comparison, caused a relatively brief spike above 1.0%.
Ten-year treasury yields found support at 3.40%. Expect either consolidation or a reaction to test the long-term moving average. The rising yield differential indicates that bank margins are improving, but financial markets are likely to suffer from the after-effects of the 2006/2007 negative yield differential for most of 2008.
Three-month treasury bills yields have recovered from the sharp fall last week, but the strong down-trend continues.
The wide spread between treasury bill and commercial paper rates reflects investors aversion to lending in the financial markets.
Total asset-backed commercial paper in issue declined below $800 billion, with banks forced to take debt back onto their balance sheets as investors shun new offers.
Corporate bond spreads remain at levels last seen during the 2001 recession.
Bank credit growth is rising sharply as the Fed's liquidity measures take effect. Unfortunately the figures are somewhat distorted by the break-up of off-balance sheet structures.
Conference Board consumer confidence and University of Michigan consumer sentiment surveys both record a significant drop in their March 2008 readings. Falls of this magnitude normally herald the start of a recession.
Jonathan Wright's recession prediction model shows probability of a recession in the next four quarters fell to 2 percent.
I would prefer to stop publishing the model, as I believe it failed to predict the current recession in a relatively low interest rate environment. Some readers, however, have indicated that they still find it useful; so I continue to include it, solely for their benefit.
The trouble with most people is that they think with their
hopes or fears or wishes rather than with their minds.
~ Will Durant.
To understand my approach, please read Technical Analysis & Predictions in About The Trading Diary.