Candidates for “quote of the week” are coming in thick and fast this morning.
There’s Alan Greenspan, the world’s least self-aware man, gently berating the US for “pursuing a policy of currency weakening”, in the Financial Times this morning. You may remember that a strong dollar policy was not an obvious feature of Greenspan’s regime at the Federal Reserve.
Then there’s our own Mervyn King. As he unveiled the latest quarterly inflation report, the Bank of England governor noted that in two years’ time, it’s “about as likely that inflation will be above the target as below it”. In other words, ‘we haven’t a clue, but we’re getting a bit worried that this deflation thing was a complete red herring’.
But I think the winner, for sheer black comedy, has to be this cracker from George Papaconstantinou, the Greek finance minister (thanks to the FT’s Short View column for this). In attempting to reassure the world that Greece is not about to go bust, he said: “Greece is not Ireland”.
I couldn’t swear to it, but I’m pretty sure an Irish official said something similar during the Greek crisis earlier this year. Ah, sweet irony.
What sparked the panic in the Irish market yesterday?
Irish bond yields hit their highest level since the euro launched yesterday (again). The cost of borrowing over ten years shot up to 8.64%. That’s also a record in terms of the gap between Irish and German borrowing costs. And it’s not getting any better this morning. They’re up to 8.9% now.
Don Smith, economist at interbroker dealer Icap spells it out on the front page of the FT: “The Irish situation seems to be getting worse by the day. These yields are unsustainable. Ireland is close to losing credibility among investors, if it hasn’t already.”
What happened yesterday? There’s been a lot of fear in general over Irish debt. We’ve written about this already (The eurozone is heading for a fresh crisis). But something quite specific ignited the big panic move yesterday – a margin call.
One of Europe’s biggest clearing houses – LCH.Clearnet – is now demanding a 15% deposit against any positions held in Irish bonds.
How does this work? One way that banks access cash is via the repurchase (repo) markets. Effectively, they sell bonds to other banks for cash, and agree to buy them back at a future date for a slightly higher price. It’s a bit like going to a pawnshop, only you don’t have to pay as much interest.
LCH.Clearnet stands in the middle of this deal. It takes on the ‘counterparty risk’. So if either party fails to meet its obligations, LCH will take the hit. But just as some items of collateral will get you more money at a pawnshop, the same goes for the repo markets.
Irish bonds are damaged goods, to put it politely. So now any bank or institution wanting to use them as collateral has to put up a 15% margin as well. That’s to cover the risk to LCH.Clearnet in case the pledging bank fails to honour its commitment.
Naturally, some banks and traders dumped their holdings of Irish bonds rather than have to find the extra money, thus pushing prices down and driving yields up.
So this is just a technical thing then? Sadly, not really. The reason that margin requirements go up is because an asset looks more risky. So while the move might have made things worse, it only happened in the first place because investors are clearly losing faith in Ireland’s ability to repay its debts.
Special FREE report from MoneyWeek magazine: Don’t be fooled – house prices will fall again!
- Why UK property prices are set to collapse by 30%
- When it will be time to get back in and buy up dirt cheap property
Ireland is on the brink
Ireland is in a mess sadly. The commitment it made to stand behind its banks – which looked like a pretty sharp move when everyone was panicking in 2008 after Lehman collapsed – has brought the country to the brink, despite the government’s best efforts to push through austerity package after austerity package.
Now the worry is that a wave of repossessions and people defaulting on their home loans will be the next big problem for the banks – and thus, the country. David Duffy of the Economic and Social Research Institute, an Irish think tank, reckons that a quarter of all home loans will be in negative equity by the end of this year. In other words, the home owners will owe more than their homes are worth.
Ireland doesn’t have to borrow any more money from the markets until 2011. But the worry is that by that point, it will effectively be locked out of the markets, and have to turn to the European bail-out mechanism. No one is quite sure how that would work.
And it doesn’t help that the Germans and now the French are threatening to force bondholders to ‘share the pain’ after 2013. There’s nothing wrong with the idea. And the truth is that, politics being what it is, the only time it could ever be pushed through is now, when there’s a sense of urgency and outrage. But it does mean that the periphery countries are being hung out to dry.
What does it all mean for British investors?
Well, it looks as though the euro is back on the defensive against both the pound and the dollar. And unlike the last time the euro was in trouble, sterling looks to be in a rather stronger position. As I noted above, the Bank of England seems to have no idea where inflation is heading, which also suggests that quantitative easing in the UK is off the cards, certainly until 2011.
Now, we wouldn’t recommend buying or selling assets based purely on the currency they’re denominated in. However, if you do fancy betting that the pound will continue to gain against the euro, then spread betting might be for you. Do understand that betting on currencies is pure speculation and that when spread betting you can lose a lot more than your initial stake – it’s very risky. If you’re still keen, you can compare brokers (and also pick up some trading tips) in our spread betting section.
Our recommended article for today
Keep buying gold – but for how long?
The reason people are stockpiling gold is to insure against financial meltdown. The price won’t start falling until they decide the dangers have passed. Bengt Saelensminde looks at when that might be.