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In my last blog I noted how the investment banks are doing very well. Borrowing at 0.5% and investing in government bonds yielding more.
A similar but far more destabilising transaction is the current US dollar carry trade. Speculators appear to be borrowing in US dollars at 0.5% in their droves and investing in other risk assets such as commodities and emerging markets, driving the dollar down and inflating risk assets. The longer this goes on, the bigger the bubble gets. Question is, when does it stop?
Will interest rates be able to remain this low for as long as the central banks have stipulated? All other things being equal, you can see low interest rates for a long time given there’s so much spare capacity in the economy, but it’s not as simple as that. The speculative money going into risk assets is driving up the costs of raw materials and this is especially hurting those whose currencies are weakening such as the US. It’s especially inflationary, a one way track to stagflation. That’s little or no growth with inflation. Typically, in order to control inflation interest rates are raised to temper demand. This is happening in Australasia for example. But what do you do when there’s little or no growth such as in the US and UK? Rather than tempering domestic demand, interest rates may have to increase just to improve the exchange rate and dampen import inflation. That would certainly help appease China who are also getting concerned. But this would desperately hurt the real economy, the innocent bystander in all of this.
Higher interest rates will also spell the start of the unwinding of the carry trade. Once the unwind starts, it’ll be like a high speed train – no one wants to be the last one holding risk assets using borrowed dollars. Theory dictates that asset prices will fall dramatically (yes, that includes gold) and the US dollar will rise dramatically.
When will this happen? Ah, if only we knew. Bubbles can last years! But what we do know is to be careful. It’s important to know why asset prices rise and fall, who benefits and what happens in the long run. Timing the markets, the average investor gets it wrong. Buy high, sell low is typical. What you can see is a current case for commodities, growth stocks and gilts in this rally; gilts and the US dollar for when the unwind occurs. These assets pay little or no dividends. Many forget the importance of dividends which are a vitally important aspect of stable returns.
Either play one of the the biggest games of casino ever played or, if you are trying to plan for the long term amongst all the noise, diversify your assets ensuring exposure to dividends.
Last week was quite a week in the money merry go round.
On Monday, we had what the City hopes to be the final bail out of Lloyds and RBS costing £38bn, just a week after the Government robbed the private sector banks of their deposits when it offered it’s market leading, 100% backed, 1 year fix of 3.95% gross. I don’t think RBS is out of the woods just yet.
On Tuesday, Australia put up their interest rates again from 3.25% to 3.50%.The likelihood is that the UK will be among the last to put up rates. Together with the likelihood of on-going Quantitative Easing (QE), that will make less people wanting to hold pounds pushing down sterling.
Thursday saw another £25bn added to the QE programme, that’s the Bank of England buying gilts using money from thin air to increase cash assets at the banks which in turn are meant to be loaned out. Evidence suggests not much is being loaned out, but the low gilts yields and low interest rates have meant that to get a decent return, money has gone into risk assets, creating a boom in share prices and a better climate for new share issues/fund raising for flagging PLCs. For big business to start with, it seems that QE is working. It is especially beneficial for the Government. Low gilt yields mean the cost of servicing Goverment debt is kept low – for now.
Had the Bank of England bought private sector debt then borrowing costs might have lowered in that sector, helping small businesses like policy does in the US. Hmmm.
What we can deduce from last week alone is that the UK’s enormous hangover from the debt bubble is still having to be repaired with the loosest monetary policy seen in our lifetimes whereas the likes of Australasia are looking to put the brakes on. This will keep sterling weak, providing a prolonged break for UK tourism and a boost to international investment returns for UK investors.
Oh, and the investment banks have been doing quite okay from all of this. Huge gilt issuances have been profitable for the banks and George Soros recently asserted that “banks are getting … hidden gifts from the government” because they can “borrow at effectively zero and buy 10-year government bonds at 3.5pc”. Hmmm. What with the QE programme of buying gilts from banks, it sounds like a merry go round of debt in the UK to me, further pushing gilt prices up and gilt yields down until someone or something puts a stop to all of this.
