Yong-Long Lai

Fed disappoints Wall Street by cutting funds rate by only 25 basis points, but

Equity markets are ignoring the moral hazard dilemma faced by newish Fed Chairman as he tries to

Escape so-called Greenspan Put

Asian equity markets drop in sympathy with Wall Street, but not as sharply

Debt risk premia spreads still high in US, although not rising any further

Fed and RBA will be troubled by persistence of high short-term risk premia in US

Spread of 90-day bank bills over cash still on the rise due to contagion from US debt markets

Australian dollar the fist casualty of Fed s smaller, rather than larger funds rate cut as

FX market s appetite for high yielding risk assets wanes again, while

US dollar finds TWI floor – at least for now, so

$A weakness as much as anything is the flip side of $US strength

Risk of another local cash rate increase retreating, although

Still by no means extinguished

December quarter CPI in late January still pivotal

The Fed s moral hazard dilemma came back into sharp focus overnight – not that it had even gone away, mind you – when equity markets recent optimism was deflated – literally – by disappointment at the cut of only 25 basis points. The rally on Wall Street in the lead up to last night s decision had been heavily predicated on expectations that 50 basis points would be delivered in the face of a proliferation of evidence that the US economy is on the verge of at least a sharp slowing, if not recession in 2008 as sub-prime contagion unfolds.

The Fed was always going to tread more softly than equity markets were hoping for at least once during the sub-prime crisis, the only genuine surprise is that Wall street was surprised by it this time. Unlike equity markets themselves, the Fed has to balance the legitimate need to keep the wheels of the global financial system turning with the parallel imperative to keep a lid on inflationary pressures and not reward excessive risk taking by slavishly easing monetary policy aggressively when bubbles created by earlier loose monetary policy burst.

It s not as if we haven t seen it all before – and at roughly 10-year intervals to boot. The Fed led other central banks in easing monetary policy straight after the October 1987 stock market crash, only to be back in a tightening phase by May 1988 as inflationary pressures that were already building were given a kick or two along by the cheaper credit. And while the subsequent 325 basis point increase in the funds rate in the late 1980s may not have been the only reason for recession in most industrial economies in the early 1990s, it was certainly the prime suspect.

Emboldened by his success at rescuing the real economy from the shock to the financial economy in 1987, the current Chairman s immediate predecessor, who had been appointed not long before the 1987 equity market crash, did the same thing in late 1998, when the collapse of the high profile hedge fund, Long-Term Capital Management (LTCM) threatened to trigger fire sales of global assets, with all the adverse implications for that real global economy once again coming back into play. Once again Dr Greenspan grabbed victory from the jaws of defeat by easing monetary policy, only to be tightening again by the middle of 1999 as the tech bubble took on alarming proportions. And its bursting with the vaporisation of the NASDAQ in March 2000 was the start of the recession of 2001.

And even though the most recent recession in the US was mild, the Fed eased monetary policy aggressively from early in 2001 – long before 9/11 – and kept easing until the threat of deflation that took hold in the middle of
2003 had passed without incident. But all of this took the funds rate to just 1.0% pa for an entire year, during which time the sub-prime bubble took centre stage. And the whole time the funds rate tracked at 1.0% pa, Japan s equivalent was zero (yes, 0.0% pa), while the common euro rate was 2.0% pa, meaning the simple average of the big three cash rates was just 1.0% pa.

Even in the context of the low and stable global inflation prevailing back then – the oil price averaged $34 a barrel during the period when the big three cash rates averaged 1.0% pa – the rate of return in cash markets was just too low to entice anyone to hold cash, so the great search for yield drove up the price of all manner of risky assets, including those tied to the sub-prime mortgage market.

At it was not only investors with surplus funds – borrowing at ultra cheap cash rates and cash and carrying investments in higher yielding assets was rife in the early part of the decade. But to the extent that the right balance between risk and return was ignored, glossed over, or apparently transferred to someone else by use of derivatives, the sub-prime fallout is the legacy of crystallisation of losses in at least one class of risky assets.

So the current Fed Chairman is faced with the dilemma of trying to limit losses to the sub-prime space without sowing the seeds of a new bubble somewhere else in the future – be it nanotechnology, water rights or maybe carbon emissions trading. While Dr Greenspan had no qualms about letting bubbles inflate and then cleaning up the mess when they burst by aggressively easing monetary policy, the newish guy, now faced with his own first big test 20 years after the stock market crash, has one eye on the current mess (ie the sub-prime fallout), but the other on the next mess, wherever and whenever it may crop up.

So now equity markets are screaming that the Fed is behind the curve and in denial of the risk of recession in the US. Or are equity markets themselves in denial of the whole moral hazard concept? Either way, at the very least the first casualty is the Australian dollar, as the global foreign exchange market s appetite for high yielding risk assets takes a breather once again, as it has done more than once since sub-prime losses started to mount. But the local currency s latest bout of weakness also reflects the tentative bottoming of the US dollar, which is now almost a month old. The aussie s long ascent was always mainly the flip side of US dollar weakness, so if the big dollar is about to enjoy a renaissance, the local currency will probably retreat further from its recent 23-year high against the greenback. You probably haven t heard too much talk of parity with the US dollar around the water cooler in the last couple of weeks. And it was never our base case expectation anyway.

While equity markets are in lather about the Fed not understanding their needs today, US debt market risk premium spreads have at least stopped rising, although they remain well above normal – whatever that is. The Fed would not be too concerned if the bond premium stayed high, because it was too low in the middle of the year. But the persistence of an 80-90 basis point spread of 3 month commercial paper over equivalent overnight index swaps (OIS) would very much be of concern to the Fed, because it could be one of the mechanisms by which the contemporary shock to the financial economy is transferred to the real economy.

And the other most likely way sub-prime contagion could jump species is if the US consumer cuts back spending markedly in the face of falling house prices – not to mention rising home heating costs as winter sets in and gasoline prices in the face of an oil price that continues to hover around $90 a barrel. Recession in the US in 2001 was mild because private consumption, which accounts for 80 per cent of GDP, slowed only modestly.
But house prices kept rising in the wake of that recession. By contrast, they are now falling at a similar rate to the depths of the recession of the early 1990s, when private consumption really did fall out of bed. So tomorrow night s November retail data is of more than passing interest.

And while the RBA is giving subtle recognition to the school of thought that Australia has de-coupled from the US economy by latching onto China s insatiable appetite for coal, iron ore, nickel and LNG, the local central bank will also be troubled by the persistence of high risk premia at the short end of the US debt market, because while the US may not be quite the economic superpower it once was, its debt market still punches well above its weight division in respect to its influence on other open debt markets
- just as the Dow still dictates the direction of the rest of the world s equity markets.

The next reading on local inflation in late January is still pivotal to the outlook for Australia s cash rate, but the first hints of a change of heart by the RBA were apparent in the statement they issued last week when it left the cash rate unchanged. A lot can, and probably will, happen between now and the RBA s first Board meeting of the new year on the 5th of February, not least of which is the Fed s next meeting on the 29th and 30th of January. Not that we are yet prepared to abandon our base case expectation of one more cash rate increase in the first half of next year, but the probability that should be assigned to it is perhaps now more in the vicinity of 60 per cent, rather than the 75 per cent it was maybe a couple of weeks ago.

The spread of local 90-day bank bills over cash continues to rise, although whereas expectations of a higher cash rate had been a key reason for the rising spread until very recently, the latest surge seems to be a direct result of contagion to the local market from the US.

Base metal prices continue to struggle in the face of legitimate doubts about the durability of the strong global economic growth that has underpinned the great commodity price boom of recent years. Lower commodity prices in general would dampen some of the RBA s concerns about upside inflation risk, but they remain not that far shy of historical highs, so unless expectations of even higher coal and iron ore prices next year are dashed, a key driver of Australia s economic growth is likely to remain more than conducive to the maintenance of robust business investment in 2008.

(See attached file: WEEKLYSNAPSHOT12DECEMBER2007.pdf)

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Alan Langford
Chief Economist
HBOS Australia
Level 8
BankWest Tower
108 St. Georges Tce, Perth
Western Australia 6000
phone: +61 08 9449 6354
fax: +61 08 9449 6266
e-mail: alan.langford@hbosa.com.au

The information contained in this publication is of a general nature and is not intended to be nor should it be considered as professional advice. You should not act on the basis of anything contained in this publication without first obtaining specific professional advice. To the extent permitted by law, HBOS Australia Pty Ltd, its related bodies corporate, employees and contractors accepts no liability or responsibility to any persons for any loss which may be incurred or suffered as a result of acting on or refraining from acting as a result of anything contained in this publication.

WEEKLYSNAPSHOT12DECEMBER2007.pdf