The banking system has broken down and central banks will have to cut rates: Kohler

The 4% bounce on Wall Street can, perhaps, best be characterised as a hope rally: hope that yesterday’s 8% crunch shocked Congress enough that the rescue can be rescued. Some incurable optimists are even suggesting that Monday’s debacle was a good thi

The 4% bounce on Wall Street can, perhaps, best be characterised as a hope rally: hope that yesterday’s 8% crunch shocked Congress enough that the rescue can be rescued.

Some incurable optimists are even suggesting that Monday’s debacle was a good thing because a better package will now get passed – something more like 1992 Sweden than 1990 Japan – but that seems unlikely at this stage. Right now, the view would be that just about anything will do.

More likely is that an inadequate bailout will be passed this week and Treasury Secretary Hank Paulson will be back for another round with Nancy Pelosi and Barney Frank in a few weeks time, and then again in a few months.

Meanwhile, the American banking system remains effectively insolvent and global central banks have become the liquidity providers of first resort, because private banks and sovereign funds are not letting their cash out of their sight. As a result, money markets have broken down completely.

The London interbank offered rate (Libor) registered its largest ever one day rise last night – jumping 431 basis point to an all-time record of 6.88 %. The Libor-OIS (overnight indexed swap rate) spread, which is a measure of the scarcity of cash, also a hit a new record last night of 246 basis points.

A fixed income strategist with Dresdner Kleinwort in London, Christoph Riegert, was quoted thus by Bloomberg: “The money markets have completely broken down, with no trading taking place at all. There is no market any more. Central banks are the only providers of cash to the market, no-one else is lending.”

Bond yields, however, kicked up, reversing the recent trend of rising long-term bond prices. But it’s likely to be a brief bull market correction: it seems clear that despite the claims that the US bank bailouts and money printing will produce Zimbabwe-style hyper-inflation, any inflationary impact of this crisis will be overwhelmed by the recession. As a result bond yields are likely to keep falling.

In fact deflation will rapidly become the economic concern du jour, and co-ordinated interest rate cuts will soon be added to the already very full action plan of the world’s central banks.

Up to now they have been careful to separate liquidity operations from monetary policy and, indeed until recently, to continue warning about inflation while pumping liquidity into a cash-starved global financial system.

If they hadn’t already understood that inflation was no longer a problem — and hasn’t been for six months since Bear Stearns collapsed – they would certainly have understood it after yesterday’s Congress vote on the Paulson bailout.

Even if a revised version is passed this week, it will be inadequate. Most predictions of potential total bank losses from the crisis now cluster around $US1.5 trillion – twice as much as Paulson asked for, and four times as much as Congressional leaders were prepared to give him before they were also knocked back.

That means the financial system and the economy will continue to be dogged by bank failures and falling US house prices.

Merrill Lynch analysts said yesterday their models suggest that there is another 15-20%t downside for house prices because the stock overhang is now at 11 months supply. If that’s right, we are only half way through the real estate deflation, since the national median has so far fallen 20%.

As a result Merrill’s analysts have concluded that the Troubled Asset Relief Program (TARP) needs to be twice as big as suggested, that Paulson and Ben Bernanke are underestimating the scale of the problem and that a ferocious consumer recession and deflation is about to be visited upon the United States.

Why won’t the government debt creation be inflationary? Because while money supply will increase, its velocity will decrease. That’s what happened between 1989 and 1993, when the Fed re-inflated but money velocity contracted 13 per cent and inflation was cut in half.

It’s not just the US. The following countries are now in or close to recession according to Macquarie Bank’s Rory Robertson: the US, the UK, Japan, Italy, Canada, Germany, France, Denmark, Ireland, Iceland, New Zealand, Portugal, Spain and The Netherlands. (Australia anyone?).

Robertson believes that the US Fed will cut the Fed funds rate to 1% or lower, that the Reserve Bank will cut to 5% or less, and that the Bank of England, the European Central Bank and the Bank of Canada will all cut.

If he’s right, share markets will probably rally into the rate cuts, but that will be a selling opportunity – possibly the Last Chance Saloon. Recessions and deflation will likely cut into company profits more deeply and for longer than currently expected, especially among resources stocks.

A lot depends on whether the US sticks with the Japanese-style bailout of 1990 (called Price Keeping Operation after UN’s Peace Keeping Operation) or goes for the Swedish birch branch approach.

In 1992 Sweden’s seven largest banks, with 90 per cent of the market, suffered losses equivalent to 12% of the nation’s GDP. The government and the opposition jointly announced a general, open-ended guarantee of the entire banking system, which protected depositors but not shareholders – who were entirely wiped out.

As a result Sweden’s stockmarket and economy recovered much more quickly and decisively afterwards than Japan’s, which took a decade.

This article first appeared on Business Spectator.