John Redwood

|

Writing on his blog, www.johnredwoodsdiary.com, the Rt. Hon John Redwood MP today pointed out the role of the Central Banks in the financial instability and fall in share markets we are now seeing. John Redwood predicted the market falls in his blog last

“Yesterday, share markets around the world were in free fall.

That came hard on the heels of the Bank of England forecasting a further rise in UK interest rates, and saying people owning high risk debt had to accept it was overvalued. They should expect no bail out.

It followed the Fed keeping rates on hold and telling holders of risky debt to accept their losses. The Fed too denied any wish to ride to the aid of institutions that had made bad loans.

It was taking place as the European Central bank pumped more than £60 billion of money into the banking system when it became alarmed that the dodgy debt crisis had spread to European banks.

Some market participants were more spooked by the actions of the ECB, who drew attention to the serious nature of the European banks’ involvement with sub prime and other risky debt by easing to accommodate it. Others will be more spooked by the reluctance of the Fed to cut interest rates to ease the crisis, and by the Bank of England’s approach of wanting to inflict more pain on borrowers to be sure they have squeezed inflation out, having lost control of price rises against target sometime ago. Still others want to go on squeezing inflation but don’t want to accept this means lower share prices as well as falling bond prices.

The market falls should come as no surprise to readers of this blog.

On July 5th I wrote:

“So far the general view is that the sub prime mortgage market will continue to be in distress, but these problems will not spread. However, a similar pyramid of debt has built up around company borrowing  around the world. If the Fed, the ECB and the Bank of England keep raising interest rates there could come a tipping point where there was a sharp fall in corporate debt markets just like the sub prime collapse”

On 14th July I reminded readers of the overextended state of western financial structures:

“This buying (of the dollar by Asian countries) has enabled the US and other western countries to carry on borrowing, building the credit house of cards which characterises the modern western economy”

On 25th July: “There are billions of dollars in all sorts of fancy and clever arrangements and funds which will need to fall in value if the squeeze goes on”

On 26th July: “If they (the central banks) don’t back off soon it could be quite a collapse”

The Central Banks call the shots. All of the decline so far has been caused by the decision to raise rates substantially in the US, the UK and Euroland, and to effectively force the banks to tighten their lending criteria. Both the Fed and the Bank of England has been saying there will be no premature easing or bail out. The ECB has been saying it will carry on tightening, looking at the relative success of the German economy and its inflation fears. Suddenly yesterday it worried about the state of some banks and funds. Presumably it had realised before that European banks and funds have bought many of the highly borrowed instruments coming out of the US that are now caught up in the so called sub prime and wider debt problem, but chose yesterday to highlight it.

Why can the damage spread from bonds, from borrowings, to shares? For several reasons:

The first is that banks and funds needing money will often find it easier to sell shares where they have good profits, to help them tackle the losses and cash shortage they have got into by dealing in debt instruments that have fallen. They often have to put more money up because the underlying “asset” has fallen in price and that requires them to pay more “margin” when they are dealing in certain types of financial instrument based on that underlying asset.

The second is that the losses from holding dodgy debt will in part be made by financial service companies, investment funds and banks that are quoted on the stock market. You would expect their share prices to fall - if all other things are equal - to reflect those losses.

The third is that if the Central banks carry on with the squeeze it will hit people’s ability and willingness to spend.

The fourth is that as bonds start to offer a better income, people will expect shares to do the same, which means some combination of lower share prices and/or higher dividend increases.

What is clear is that different approaches by the main three western central banks are not helping create stability. Yesterday’s big falls occurred when the ECB took a different approach from the Bank of England and Fed.

Every word and every action from the Central banks now matters greatly. They have to decide when they have squeezed and rattled the markets enough.”