How I learned to stop worrying…

How I learned to stop worrying…

A headline last week asked if we should be worried about the banks. There have been relatively few times when worrying about the banks has not been in vogue, but now is not one of them. The cap on UK deposit protection was reduced last year to £75,000 per account, to reflect the strength of sterling as the EU wide bank deposit protection scheme is set at €100,000. Given sterling’s current weakness, it may well have to go back up again!

On top of that we are now in a position where any future bank failures, across the EU, will be dealt with by way of a bail in, not a bail out. Under a bail out the banks are given taxpayers money by the government. Under a bail in the banks take money directly from taxpayers’ bank accounts ie if you have more than the deposit guarantee amount you would kiss it goodbye if your bank failed. The residents of Cyprus, including a not insignificant number of ex-pat Brits, found out the hard way how this worked in 2013. They received little sympathy from the main stream media as anyone holding over €100,000 was quite obviously either Russian, an arms dealer or both. There were a few of those, but most of the “serious” money escaped as on the weekend before the banks were closed on the Monday; the London branches of said banks opened for transfers, a facility gratefully taken advantage of by those “in the know”. That didn’t include many ordinary Cypriots whose businesses have still not recovered and whose life savings have mostly vanished forever.

It couldn’t happen here could it? Well it’s one of those “things that makes me go hmm”. Bank CDS across Europe have been rising sharply which doesn’t necessarily spell imminent disaster, but do have a look at the chart of Deutsche Bank and see if that makes you feel any better.

And it’s not just the commercial banks. The world’s central bankers seem to have lost control of their senses too. The ECB and the BoJ have both instigated NIRP – Negative Interest Rate Policy – which directly translates into negative nominal government bond rates in almost all European countries – as well as Japan – along some part of the yield curve. In Switzerland it’s all the way out to 10 years; Japan has just got there too. The UK 2 year rate is a heady 0.03%; still positive by the skin of its teeth, but negative in real terms…

This just doesn’t make any sense. What the central banks are, in effect, saying to the rest of the banking system is “You haven’t got the message yet. You haven’t made enough loans, so get out there and do it, otherwise we’ll keep cutting until you do because we have run out of fresh ideas and the only thing we can do with this piece of string is push on it.”

The bond market is saying that zero/low real GDP growth plus zero/low inflation equals zero/low nominal GDP growth, which means debt/GDP ratios will keep increasing, which means governments are less able to repay debts, which means bond yields should be going UP, not DOWN! (thanks to Kevin Doran at Brown Shipley for that observation)The world has truly gone mad and we are living in a Dr Strangelove world…and we know how that ended!

The Swiss and Danish central banks are using the same policy, but, in this case, to stem the unwelcome attraction of foreign inflows. As we saw with the Swiss franc early in 2015, when the weight of money overwhelms the central bank the inevitable happens. The People’s Bank of China believe that they too can defy the markets. The Chinese have already thrown a lot of money at their equity market, to little effect, and have spent well over $1 trillion of their reserves supporting the yuan in the face of “imperialist running dog speculators”. A recent People’s Daily op-ed was entitled “Declaring war on China’s currency? Ha ha!” which must have left George Soros quaking in his boots!

They want to manage the yuan downwards at their own pace and not to be seen to have been forced into that position; loss of face is very important in this part of the world. The reality of the situation is that everyone else is busily devaluing and this is making Chinese goods less and less competitive. They need to devalue and by a significant amount. Back in 1994 they devalued by nearly 30%; all in one go. The cheapness of the currency attracted huge foreign investment allowing the Chinese to “come out of the dark ages.” They need to do the same again. If they try to defend the currency they will eventually run out of their foreign reserve buffer and still have an overvalued currency.

They have been facilitating a very profitable carry trade by capping currency and credit risk for a long time so switching horses, as it were, to facilitating currency speculators shouldn’t be a problem for them. The Chinese are inclined to have a long term perspective, which is in direct opposition to the FX market that likes to get where it wants to go with some alacrity. There will be a war of words against the “running dogs” who will ultimately get the “blame” for the inevitable devaluation thus saving face and giving everyone involved what they want.

When the yuan devaluation happens the Hong Kong dollar peg will almost certainly go with it too. At that point it will be time to start getting back into Chinese equity markets, but for now it is a patient waiting game.

To download a pdf version please click here