When I started in the City of London, the UK was entering a terrible period. Sterling was in free fall and the IMF were being called in by the then Prime Minister James Callaghan. His nemesis came in the form of Margret Thatcher who boldly stood on the election platform in 1979, tearing a Pound Note in half and claiming that the Pound in your pocket was now worth half of what it had been. It helped the Iron lady to take power and become the UK’s longest serving Prime Minster, just recently surpassed by Tony Blair. However, this was a revolution created by the need to move the basics of economics to monetarism. This has been the foundation for the strength of the British economy for the last 25 years. A process that was not easy or painless.
So the question confronting the markets today are simple is this just history repeating itself. After all, the similarities are stark. The current incumbent in number 10 is the ex-chancellor as was Callaghan. The property market was coming under pressure but not yet in free fall. The government was suggesting long term wage settlements and the Oil crisis was just getting started. The trigger of course was the falling pound that started what was to become a very uncomfortable transition for the majority.
So where is Sterling at the moment? The answer is not in a very secure place. After a year in 2007 where the US Dollar was the dog of the foreign exchange market and Sterling had enjoyed the same strength as many of the other majors. Running to the end of the year though a lot of this strength seemed to evaporate quickly. The cause was credit markets and the twin deficits. The global credit crisis which in reality is more a western problem rather than a global issue started to bite in August. The problem for Sterling was that much of the attraction had been the high interest rates in comparison to others and the booming financial markets that are the main driver to the UK economy. This was the magical carry trade that has been the focus of the markets for some time.
What is a carry trade? In its simplest form it is the ability to borrow in one country and lend in another at a better return. The only issue with this is that you need the currency to continue the upward momentum to assist the game and the credit markets must remain solid and free flowing. In the case of Sterling when the subprime crisis started to be a real issue in August. The carry currencies such as Sterling/Yen stopped and corrected violently as the appetite for risk diminished. It wasn’t though until late November when the depths of the freeze in the interbank and credit markets occurred and the reality that economic background was slowing in the US and the UK in particular that the carry trade again came under pressure. The position now exists that the credit window has closed and it will be a case that the mega end of year smoothing operations from the central banks will be tested soon enough. All of the combine influences has now led sterling to a very weakened position.
The check point is whether the cut in interest rates in December will be matched in January. If it is, then it will create a further double edged sword for the UK’s Bank of England. After all it is a central banks role to manage the inflationary pressures and the longer term growth picture. It is clear that the dream of a permanent growth is a nirvana that is impossible to achieve and even more impossible if the central bank has ignored the hyper inflation that existed in the asset markets as both the US and the UK did. This was driven out of the carry trade that created a credit tsunami of investment cash into these high yielding countries. The problem is that Tsunamis wash deep inshore but when they withdraw they leave a lot of debris in their wake. The issue now for the Bank of England is that the carry trade cash is vanishing quickly and there is nothing to replace it. So the asset bubble comes under threat. So rate reduction to create the opportunity to sustain growth also reduces the carry argument, thus a vicious negative circle is created. The very reason the carry existed fails and thus the desperately needed credit needed to support a fractured credit market remains withdrawing to safer havens.
This is a difficult balancing act that is not easy to achieve. The problem is that the US stayed in denial for a long time over the extent of the subprime and its real risks to the economic background and the consumer. The UK now faces similar problems. The deepest problem is the credit markets must be unfrozen. The belief is that rate reduction is the path to find that solution. This is questionable at best. The issue in the interbank market is one of trust as the credit bubble has been collapsing. The reality is that the depth and extent of the losses from subprime and near subprime are not as transparent as the central banks and the politicians believe. The issue is that it is confidence that has to be restored, one of trust! This is also the problem that exists in the political arena as well.
Looking at the current US election race, it is clear that the candidates are all on the same path change and trust. The trust of the electorate is as damaged as the trust in the interbank market. The reality is that the credit market crisis is no different to other times this has occurred, very similar in fact to the savings and loans disaster that beset the US in the 1980s. It is a case that the Banks need to rebuild their balance sheets and this is very hard to achieve with low interest rates. Clearly, a prime borrower will be a prime borrower whether interest rates are five percent or 10 percent, thus the difficulty that the central banks now face. The political pressures will be to cut rates to give the allusion that growth will be protected. The problem is that this would be a successful direction if like post 9/11 the Tsunami of the carry trade money had not rolled in. Thus the path seems set. The central banks will continue to cut rates to relieve the panic in the markets to try and unblock the interbank and credit markets.
Double edged sword
This is where the last piece of the jigsaw starts to fall into place. In the UK which is a net importer a falling pound will lead to imported inflation and this is where the double edged sword comes into play. A frozen credit market linked to rising inflation in an environment of twin deficits makes the ability to reduce interest rates harder. The problem then becomes dramatic as faith in the economy and the country falls. Thus the chances of a currency recovery become less likely until the twin deficits are being tackled and seeing resolution.
We started this article reminiscing over the rise to power of the iron lady. It is clear that periods of fractured credit markets require decisive leadership and this develops the need for radical change. The change appears to be happening in the US. The UK though still lacks any clear decisive leaders, whether this continues remains to be seen. The incumbent party and the opposition are in a state of flux with both starting to question the leadership and the future direction. So while we are probably only in the beginning stages of a political and financial change, it is a path that looks like it may well be a trodden through necessity rather than desire.
Sterling remains pressured and we are expecting that we will see parity against the Euro and a continuation of the unravelling of the carry trade. 2008 may well become the year where Sterling takes the mantle of the dog of the foreign exchange markets which has been held so well by the US Dollar. It will be interesting to see the political fallout and this we may see first in the US with the presidential elections which may mark the start of a resurgence and recovery in the fortunes of the US Dollar though not necessarily the economy. Hard times need strong leadership with vision and these times are nearly always created from financial market crisis.