Over-reaction to events is a feature of all markets. The early economists in the 19th century observed this in agriculture. One year there would be a shortage of grain and prices would be high. Encouraged by the resulting profits, farmers would put more land out to wheat. Next year, there would be a bumper crop and prices and profits would fall. And so the cycle would go on.
Financial markets react in much the same way, although they certainly respond much more quickly than farmers were ever able to do. Arguably, they also respond to a greater degree. There appears to be little middle ground for financial analysts between the extreme optimism of a boom and the stark pessimism of a bear market.
The current pessimism of financial markets, particularly in the US, is so marked that the resulting fall in asset prices is having a material impact on the real economy. What makes this such a difficult problem for the central bankers to address is the fall in assets has largely been driven by the market’s nervousness, rather than any re-assessment of the assets’ fundamental value.
The last Bank of England’s Monetary Policy Committee (MPC) meeting identified two significant affects arising from this. First, as asset prices fall, the risks of leveraged borrowing become all too apparent. Borrowers are required to hold a minimum collateral. As the value of assets fall, the value of their collateral reduces. Ultimately, they reach a position where they are forced to sell assets in order to maintain collateral at the minimum required level. But a forced sale of assets into a falling market only amplifies the downward movement in prices.
The second impact arises from the increasingly complex structures that the investment banks have devised for securitising assets. In most financial transactions, buyers have a good understanding of what it is they are buying and what the risks related to that asset are. For the new complex derivatives, most buyers appear to have relied on assurances from the ratings agencies that the assets had minimal risk and did not validate this for themselves, if indeed this was a feasible option. As these assurances have proved worthless, certainly in the case of US sub-prime mortgage assets, buyers have begun to question the quality of securitised assets with higher credit ratings than those in the sub-prime category. Potential investors consequently have ceased buying asset-backed securities.
The response of the US Federal Reserve has been to slash official interest rates. Following the rescue of Bear Sterns – which fell foul of the risks of a leveraged borrower – the Fed made another 75bps cut to leave the reserve rate at 2.25%, having been 5.25% as recently as August.
It seems most unlikely that interest rates in the UK will see similarly aggressive cuts. I see three reasons for this. First, the UK economy as a whole is not nearly at such high risk of recession as the US is. As the MPC minutes note, indicators of activity published during the past month were more robust than had been expected. Second, and aligned to this, short-term inflationary pressures in the UK appear to have increased, and in consequence, so has the risk of higher inflationary expectations.
But for me, the most important reason why the MPC will not cut interest rates aggressively is that this will not address the fundamental cause of the current banking crisis – particularly as it relates to mortgage markets and household borrowing. The driver of the current stagnant housing market is not a lack of affordability among potential borrowers leading to a decline in demand – although affordability is weak and demand is lower than a year ago – but a lack of liquidity among lenders.
The MPC might well bring forward to April the base rate cut I had pencilled in for May, but I see the UK base rate ending the year at 4.75%, with the problems of the credit market having to be addressed by more direct and radical measures. n
