A Great Depression Warns The Central Bank Body

Run for the Trees-BIS and the Black Swans by John Needham, The Daniel Code Report | June 13, 2008

A Great Depression Ahead?

With Fed chief Bernanke trumpeting that the credit crisis is abating, a postscript to his promise that “the sub-prime problem is contained”, and asserting that the US will not see recession, punters are feeling warm and fuzzy about US markets and apart from an occasional frown about gasoline prices, generally the thrust is that the worst is over. If you are in that camp you may have to think again. As our theme photo shows, tree climbing skills come in handy when bears are on the loose.

A report from the Bank of International Settlements (BIS) carried in this week’s Banking Times drawn to my attention by Danielcode member Rob H has a very different view on what is coming down the track. This august body are not known for inflammatory stories or “look at me” blogger posturing. By nature (Swiss) it is inherently conservative. As its customers are central banks and international organizations, the BIS does not accept deposits from, or provide financial services to private individuals or corporate entities so we can assume that uniquely amongst banks it is likely to be unbiased and we can put some weight on its publicly voiced concerns.

Central bank body warns of Great Depression - The Bank for International Settlements (BIS), the organization that fosters cooperation between central banks, has warned that the credit crisis could lead world economies into a crash on a scale not seen since the 1930s. In its latest quarterly report, the body points out that the Great Depression of the 1930s was not foreseen and that commentators on the financial turmoil, instigated by the US sub-prime mortgage crisis, may not have grasped the level of exposure that lies at its heart. 

According to the BIS, complex credit instruments, a strong appetite for risk, rising levels of household debt and long-term imbalances in the world currency system, all form part of the loose monetarist policy that could result in another Great Depression. It also raises concerns about the Chinese economy and questions whether China may be repeating mistakes made by Japan, with its so called bubble economy of the late 1980s.

Levels of Pain

Of interest to impartial observers is how fragile sentiment is to relatively minor economic reverses. In US the Fed cannot bear the specter of a normally correcting market. The Bear Stearns fiasco is stark proof that the free enterprise system has effectively been abandoned at least for those privileged bodies under the wing of the Fed. Absent market discipline there is no risk and therefore no rigor. It is precisely because the capitalist system vents its fury on market failures that lessons are well learned.

Long before the Bear Stearns blow up, the Fed was propping up US markets. The over inflated and quite unrealistic valuations on public corporations must be preserved, at whatever cost apparently. This disease has now spread to UK where with minimal drops in housing prices the tabloids are screaming over the catastrophic effects on those who have abandoned savings in favour of more intensive property investments. On UK markets, Bloomberg reported today that 

“The U.K. will demand disclosure of short selling in rights offerings and may restrict investors from borrowing the stocks after plunging share prices hampered banks' attempts to increase capital. The Financial Services Authority will impose the requirements June 20. They follow a slump in Royal Bank of Scotland Group Plc and HBOS Plc as they tried to raise 16 billion pounds ($31 billion) of capital by selling new shares. Britain, regarded as the most open of the world's financial centers, becomes the first major market in Europe to put limits on short-selling.” 

What the UK authority is really doing is joining its American cousins in seeking to short circuit price discovery to the downside, a normal function and safety valve of markets.

A steadfast refusal to accept market truths is the common thread. In tiny New Zealand the last sane banker in the western world, NZ Reserve Bank Governor Bollard stated "In real terms, we are projecting a 22 per cent fall in New Zealand (sic house prices). This compares to a 38 per cent fall in New Zealand real house prices following the first oil price shock in the 1970s," Nobody is listening.

In Europe ECB President Claude Trichet is acting with teutonic stoicism which shows the benefits of pan European pretense since Trichet is actually a French bureaucrat. Totally overwhelmed by the competing demands of the sick men of Europe, Trichet is reduced to an impotent bystander. UK Telegraph’s Ambrose Evans-Pritchard has a different view:

ECB chief Jean-Claude Trichet has "signalled" a rate rise in July to combat 3.6pc inflation, much to the fury of Paris, Madrid, Rome, Lisbon and Dublin. It is a perilous path for Europe's monetary union."I would advise Mr Trichet to be more careful in his comments," said Spain's premier Jose Luis Zapatero. The counter-attack has begun. Spain's property crash is calamitous. House prices have tumbled 15pc since September, say the developers (APCE). Over 98pc of Spanish mortgages are on floating rates, priced off three-month Euribor. This rate leapt 32 basis points to 5.24pc after Mr Trichet opened his mouth. The ECB demarche is ominous for the rest of us as well. We may be watching a replay of the Bundesbank's ill-judged rate rise in October 1987, which sent the dollar into a tailspin and triggered the Black Monday crash.

The ECB official rate is 4% and has been unchanged for 12 months. They are no more going to take their medicine willingly than are US, Australia and a host of others with plenty of worse offenders in Asia. Denial to the end has become central bank policy de jure! 

Gold

No Financial Sense article would be complete without a look at the Gold market. It has not featured prominently in my recent articles as it is presently biding its time whilst it determines whether the Armageddon scenario cautioned by the BIS will transpire or whether Bernanke et al really are masters of the universe and can conjure markets at their whim. 

In NN Taleb's new book “The Black Swans,” his definition of a black swan is a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations. Taleb regards many scientific discoveries as black swans-undirected and unpredicted and applies this thought to markets. The term black swan comes from the ancient Western concept that “All swans are white.” In that context, a black swan was a metaphor for something that could not exist. The 17th Century discovery of black swans in Australia morphed the term to connote that the perceived impossibility actually came to pass.

Taleb claims that almost all consequential events in history come from the unexpected, while humans convince themselves that these events are explainable in hindsight. Beautiful Lake Taupo in New Zealand’s North Island where I spend much of the year is a collapsed volcanic cone that over the millennia has become a huge fresh water lake. On Lake Taupo, virtually at my front door, there are black swans. Hundreds of them, and nothing but black swans. And trout! Nary a white swan has ever been sighted, which might explain why I am so predisposed to black swan or “fat tail” events. I see them every day.

For Gold, the BIS scenario holds promise of a true moon shot if this black swan event transpires. Whatever the probabilities, Gold does not see them now as it works on a corrective pattern that is so far straight out of the text book:

As it has all year, Gold continues to make almost every turn on the daily chart at its DC numbers while punters assess if the correction will go deeper or if the markets’ black swan will soon swim into sight. If it does your only alternative to Gold will be to run for the trees!

I invite you to visit the Danielcode Online to get all the Daniel numbers for the extensive markets I cover. You will never be surprised by market behavior again.

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