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Inflation Fear, Rate Hikes and Bad 2008 Memories

By    |   Tuesday, 05 April 2011 09:18 AM

The People’s Bank of China (PBOC) hiked, for the fourth time since October, its key base interest rate by 25 basis points to 6.31 percent in its intent to curb rising inflation. One-year bank deposits were also raised to 3.25 percent. Chinese consumer prices jumped 4.9 percent in February and food prices jumped 11 percent.

Monday, Fed Chairman Ben Bernanke was seemingly less preoccupied on inflation than the Chinese when he said during a conference: “I think my take on inflation right now is that we are indeed seeing some increases, obviously.”

Interestingly, he attributed those increases to “global supply and demand conditions.” He added that these prices “will eventually stabilize” and “the increase in inflation will be transitory … Our expectation at this point is that in the medium term, inflation if anything will be a bit low.”

Nevertheless, he also cautioned: “We have to monitor inflation and inflation expectations extremely closely because if my assumptions prove not to be correct then we would certainly have to respond to that.”

From his side, Treasury Secretary Timothy Geithner seemed really preoccupied when he stated in an important letter to Congressional leaders. “The longer Congress fails to act, the more we risk that investors here and around the world will lose confidence in our ability to meet our commitments and our obligations … Default by the United States is unthinkable,” he said.

Geithner adds in his letter that failure to raise the debt ceiling in a timely way will push interest rates higher and spark “a financial crisis potentially more severe than the crisis from which we are only starting to recover.” He states that the U.S. will hit the debt ceiling no later than May 16.

Meanwhile, House Speaker John Boehner reportedly didn’t reach a budget deal that would keep the U.S. government operating beyond a Friday deadline in a Tuesday meeting with President Barack Obama and other Democrats at the White House.

Believe me; a U.S. government shutdown would have very nasty consequences all over the place that should catapult us in a completely different world. Yes, unchartered territory with all that implies.

Besides all that, I have the uncomfortable feeling that we could be in for a replay of the first half of 2008.

Let me explain: When I look at WTI oil that is trading at almost exactly the same level as it was in early April 2008, global forex reserves are growing at a similar pace and the euro is in demand because a big “majority” expects the ECB will raise rates on Thursday.

Interestingly, even the USD/JPY pair has provided an astonishing replay of what happened three years ago with March 17 seeing a dramatic plunge in an eerie echo of the price action seen on the same date in 2008 when Bear Stearns collapsed.

It could be argued that the euro could continue to appreciate until global growth starts slowing down because (and let’s hope not) of sustained higher oil prices, and consequently flows into emerging markets could dry up and investors “refocus” and move away from currencies supported by hawkish central banks towards those with more pro-growth policies.

Nevertheless, if the pattern set in 2008 serves as any guideline then this could take until at least the middle of the year (July) to happen.

Nevertheless, for now there is at least one major difference between 2008 and today. In the spring of 2008, the financial crisis had only just claimed its first two major calamities that were Northern Rock in the U.K. and Bear Stearns in the U.S. and the battle ground was still largely confined to the American and British housing markets.

In fact, it would take until the end of September 2008 for the systemic crisis to move from being a purely institutional one to also encompass sovereign risk after we experienced the collapse of the banking system in Iceland.

This time around, the battle is being staged in the eurozone and is taking place at the institutional as well as the sovereign level. I’m still convinced that that the loss of confidence in a sovereign state represents a far greater threat to financial stability than a loss of confidence in a financial institution.

Because of that, I’m really more doubtful about the actual strength of the euro compared to, for example, the dollar than I was at the same point in 2008. The question, therefore, is whether I’m right for making this comparison.

One realistic and objective way of comparing the relative scale of the problems is to consider the size of the bailouts.

If the loans extended to Northern Rock in the U.K. with 26 billion pounds and Bear Stearns in the U.S. with a $30 billion loan to JPMorgan for buying Bear together with another $29 billion for financing a separate entity that was charged with buying the mortgage-related assets of Bear Stearns that were the hardest to sell, then collectively we saw a bailout cost of somewhere in the region of a little more than $100 billion at today’s exchange rates.

Now, how does this compare to the bailouts of Greece and Ireland? We have the joint eurozone/IMF loan to Greece of 110 billion euros while the Nov.28 agreement reached between the EU, the IMF and the Irish state saw a loan of 85 billion euros being extended. In other words, the money lent to Ireland and Greece collectively amounts roughly to 2.7 times the amounts that were lent to prevent the collapse of Northern Rock and Bear Sterns.

If we are realistic, then we must add in the 80 billion euros that is assumed Portugal will be forced to ask for in the near future that goes from days to around three months, then the bailout number rises to 3.8 times the rescue amount that prevented the Western world from sinking into a black hole.

Besides, we should also take notice it is now apparent from the recent price action in the sovereign debt markets that Ireland and Greece still do not command the confidence of investors.

Notably Greece is currently paying an astonishing 14.5 percentage points more than Germany to borrow money over two years while it costs over 1,000 basis points to buy a five-year credit default swap on the nation’s debt, which is just higher than the cost of equivalent insurance for Venezuelan debt.

With the yields on Portuguese debt rapidly approaching the same levels of those actually being paid by Ireland, it seems reasonable to say that the collapse of confidence in peripheral eurozone states is gaining momentum rather than stabilizing. No, I can’t be optimistic.

Taking all this into account, I see serious downside risks to the euro, which is not to say that it couldn’t rise further first.

Yes, the ECB could raise its key rates first on Thursday, which would be supportive for the price of the euro at the beginning but would also be suffocating its weakest members and obliging them to “restructure” their sovereign debts that would result in damaging haircuts for the sovereign debt holders.

Yes, interesting times in the offing. No doubt about that.

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The People s Bank of China (PBOC) hiked, for the fourth time since October, its key base interest rate by 25 basis points to 6.31 percent in its intent to curb rising inflation. One-year bank deposits were also raised to 3.25 percent. Chinese consumer prices jumped 4.9...
Tuesday, 05 April 2011 09:18 AM
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