What Obama’s banking battle means for you

200-point falls in the Dow, 1%-plus losses on the FTSE 100 – why, it’s like the bad old days of 2008 all over again.

Blame Barack Obama.

Markets were already rattled by China’s moves to tighten monetary policy. But the bulls had managed to rationalise that one away as a sign that China was in control of its economy.

But now the US – the new home of the carry trade and the free money bloating global asset markets – is planning to tighten up too. Mr Obama, with the world’s most-feared ex-central banker, Paul Volcker, standing behind him, is taking on the banks. He has plenty of proposals. But they boil down to one thing – no more taxpayer-funded free rides.

And judging by the appalled reaction on Wall Street, he must be doing something right…

Banks kept interest rates too low for too long

It’s simplistic to blame the banks entirely for the financial crisis. It’s highly unlikely that anyone will ever call to account those most culpable for the boom and bust – the central bankers. Respected economists have already demonstrated (as much as is possible with a pseudo-science like economics) that the Federal Reserve and the rest of the world’s central banks kept interest rates too low for too long.

It was this government safety net, rather than the much-cited “failure of regulation” or skewed bonus systems, that was most responsible for the care-free risk taking and desperate hunting for yield that brought us to where we are now. But we won’t ever get an apology.

As Albert Edwards rather eloquently put it in a recent research note (see our blog for Merryn Somerset Webb’s take on Edwards’ piece), “The pigmies that populate the political and monetary elites prefer to genuflect to the court of public opinion in a pathetic attempt to deflect blame from their own gross and unforgivable incompetence.”

But that doesn’t mean we can just stick with the current system. We have to be comfortable with the idea of allowing banks to collapse if they make mistakes. That will encourage them to stay on the straight and narrow, regardless of what central banks do with interest rates. The smartest pundits, such as Financial Times columnist John Kay and MoneyWeek regular Tim Price (author of The Price Report), reckon the best bet is to break up the banks in some way so that the notion of ‘too big to fail’ doesn’t exist anymore.


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Obama’s big plans will be good news – if they work

And now that he’s in political trouble, Barack Obama has decided that he agrees. Obama has two big plans that have struck fear into the heart of the financial system. Firstly, he wants banks to stop betting on the markets with their own funds. This is what’s known as ‘proprietary’ or ‘prop’ trading. Secondly, he wants to prevent banks from growing ‘too big to fail’ by limiting the pace of consolidation in the sector (dubbed the ‘Volcker Rule’).

To cut a long story short, the broad aim of these plans will be to make banks smaller and less risky. And if it works, it could be good news. As John Authers puts it in the FT: “Longer term, history suggests that a reform along the lines of the Volcker rule could help shake world markets from their extreme tendency for booms and busts.”

But in the short term, it means a lot more volatility. “The danger is that a fundamentally good idea must now be filtered through a dysfunctional US Congress in an election year.”

And the US reforms are hardly the only thing investors have on their plates right now. “Traders are already worried about Chinese real estate and the Greek public sector. They must now keep an eye on every twist and turn this legislation takes in Congress.”

In other words, expect a lot more ups and downs in the coming months. Lobbyists will do their best to stop these rules from being passed. On the other side of the fence, some think the rules don’t go far enough. But at the end of the day, what will matter most is how Obama thinks the American people will respond to these rules. And they seem to be in the mood for change.

What this banking battle means for you

What should you do about this as an investor? It’s possible that this could be the trigger for a larger correction. The yen has leapt amid the flight to safety, while everything else, from gold to stocks, has taken a knock. It’s also possible that investors will rapidly regain their equilibrium – if the last decade from 11 September to last March has taught them anything, it’s to ‘buy on the dips’.

But if one thing’s for sure, it’s that now more than ever, the markets’ direction is going to be dictated by what’s going on in government debating chambers across the globe. To us, that’s all the more reason to stick with a defensive strategy. Take profits in any cyclical stocks you’re still holding, hold on to your chosen defensives, and make sure you have some sort of long-term gold holding, just in case.

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