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As expected, the European Central Bank kept rates on hold last week, but the smart money is on a hike next time. Those who parse the cryptic utterances of central bankers noted that Jean-Claude Trichet, the ECB president, used the dreaded v-word – vigilance – twice in the communiqué and several more times in a Q&A session. In the past, this has always been ECB-speak for ‘we’re going to hike next month’.
It’s good to see that at least one central bank is still overtly hawkish. There’s also a strong chance that we’ll see at least one more hike by the Bank of England before the end of this year, but the stance of the Federal Reserve is more worrying. True, some Fed members are calling for tougher rates, but the impression given by most – including Helicopter Ben – is that the next move should be down.
Some people ask why MoneyWeek worries about interest rates so much. After all, low rates make life more pleasant for most people. They mean that many of our severely-indebted fellow citizens won’t be stretched to breaking point and fall into bankruptcy. They may help prevent – or at least reduce – the looming slowdown. With inflation still relatively benign – if slightly above the comfort zone – surely we’re fretting too much. We should relax, kick back, enjoy the good times while they last.
But we think that there are two reasons to be worried. One is that it’s easy to be complacent about inflation. It’s like a dangerous dog: even if you treat if without due care, you may get away with it for quite a long time. Then, suddenly, it will turn around and bite you…
If you tolerate higher inflation for a while and let peoples’ expectations of inflation build, you can very quickly you find yourself in a nasty wage-price spiral of the kind that did so much damage back in the seventies. In that situation, people feel that rising prices are eating into their incomes, so they demand higher wages to compensate. Firms then feel that they have to raise prices again because their wage bills are going up. People then demand another wage increase because prices have gone up again. This continues in a vicious circle that can end in runaway inflation and stagnant growth.
It’s far from a sure thing, but the potential for this to happen again is present: the papers have lately been carrying a great deal of comment on whether official inflation figures really reflect most peoples’ costs of living. If that mindset takes hold, the inflation beast will break out of his cage and run rampant; it will take much higher rates and real economic pain to tranquilise him again.
But there’s a second reason to worry about low rates that’s often overlooked. Excessively low rates can push up asset prices to ridiculous extremes and create bubbles. They’re the reason why at present a rational investor can look at assets of all type and see little attractive, only to discover that six months those same assets have rocketed in value.
How does this happen? For several years, hedge funds, private-equity funds and other debt-dependent investors have been able to get extremely cheap credit. For that we can thank Alan Greenspan’s decision to slash rates to a low of just 1% a few years and the other central banks that followed the Fed down. Investors could then borrow money at an artificially low rate, which was way below the rate of return they could expect on their investments.
So they borrowed in vast quantities and pumped that money into assets of all kinds: equities, bonds, real estate, commodities. Not all markets in these assets are in a credit-driven boom, but many are. Even now, rates are still lower than they should be, so the influx of money is still ongoing.
In theory, of course, once asset prices get high enough, returns fall and the boom peters out. Most people are getting an acceptable rate of return on the assets they bought, so as long as the cost of their debt doesn’t rise too much, the market just plateaus.
But it doesn’t happen that way in practice. Credit-fuelled booms rarely plateau – they generally turn into an outright bubble. People don’t buy assets on the basis of the return they get – they just buy them on the basis that the asset prices will continue to rise as fast as they have been doing.
We can see this everywhere at moment. In property, some buy-to-let investors are happy to buy a place where the rental income doesn’t fully cover their costs because they bet that the value of the house will continue to rise at 10% a year indefinitely. In equities, investors assume that corporate profits will carry on growing as fast as they have recently and so share prices will continue going up. In bonds, they bet that interest rates will remain low, inflation benign and borrower default levels at unusually low rates.
But with every bubble, eventually there’s a trigger that tips the market down. And when that happens, when prices start falling, those heavily-indebted borrowers don’t feel so clever. The value of their assets is falling, they’re showing a big loss and they owe lots of money. So they sell to cut their losses – and then a selling panic takes hold. Investors see their peers selling and they sell. The same speculative herd instinct that propelled the market ever upward now dashes it ever downward.
And when a bubble bursts, prices often plunge far beyond what looks like fair value. The only thing that might stop the rout once it starts is if banks aggressively cut rates once more. Greenspan did that after the dotcom bubble in 2000 – and succeeded in creating a housing bubble, which has since spilled over into other assets.
Helicopter Ben might do the same – after all, he earned his nickname by saying that the Fed would print money and air-drop it into the economy if deflation threatened. But if he does, he just reinflates the bubbles. One day they’ll have to burst – and the longer that day of reckoning is deferred, the worse the consequences will be. Right now, the ECB is taking the right course of action. We can only hope that the Fed does the same…
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The FTSE 100 closed sharply higher on Friday afternoon following on-target US jobs data. The index ended the day 43 points higher at 5,949. Centrica, British Energy Group, Drax and Corus were all higher on bid talk. For a full market report, see: London market close (/file/17693/london-close-footsie-closes-on-a-high.html)
On the continent, stocks were also boosted by the good news from the US. The Paris CAC-40 closed 18 points higher at 5,183 and the Frankfurt Dax-30 ended the day 16 points higher at 5,876.
On Wall Street, the main indices closed at their best levels in three months. Tamer-than-expected wage inflation and strong consumer and factory activity sent stocks soaring. The Dow Jones closed 83 points higher at 11,464. The S&P 500 was 7 points higher at 1,311. And the Nasdaq ended the day 9 points higher at 2,193.
In Asia, the Nikkei also hit a three-month high, closing 223 points higher at 16,358 this morning.
The price of crude oil fell back below $70 a barrel over the weekend, last trading at $69.30 in New York. In London, Brent spot was at $68.64 this morning.
Spot gold last traded at $625.40.
And in London today, the free newspaper wars are set to begin in earnest with the launch of News Corp’s Thelondonpaper. The title, from the Murdoch-owned publisher of the Sun and the Times, will be in direct competition with London Lite, launched just last week by Associated Newspapers. Along with the paid-for Evening Standard, the papers will battle for the attention of the 3m commuters who travel on the London Underground each day.
And our two recommended articles for today…
Is there an alternative route to energy independence?
– As the world faces Peak Oil, we need to look at ways to reduce our dependance on fossil fuels says Justice Litle for the Daily Reckoning. Luckily, there are interesting developments under way in wind, wave and solar power. Which companies are ahead of the game when it comes to alternative energy? To find out how to go about investing in alternative energy, read: Is there an alternative route to energy independence?
What the burst US housing bubble means for the rest of the world
– It’s hard to imagine that a US-centric global economy wouldn’t be at risk in the aftermath of a bursting of the US housing bubble, says Morgan Stanley economist Stephen Roach. From American consumers to Chinese manufacturers and African suppliers, here’s what to expect from the post-bubble shake-out: What the burst US housing bubble means for the rest of the world