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A tightening in financial conditions is under way but its principal architect won't be the US Federal Reserve.
Far from it, the Fed will be pinned down by powerful disinflationary, perhaps even deflationary forces making it very unlikely to be willing to raise interest rates any time soon.
Instead, the tightening is coming from Asia, where China is fighting a local battle against rampant lending and from investors all over the world, as one by one they realise that lending to governments isn't always so risk-free.
These two forces will form a vise around still riskier assets like stocks, especially in the United States, as companies face weak conditions at home in combination with tightening from markets.
Riskier assets sold off last week after the Fed raised the discount rate it charges banks by 25 basis points, a move some argued was a sign that actual rate hikes could come sooner than expected. This was a good example of getting the right result for the wrong reasons.
Core consumer prices, excluding food and energy, fell in January for the first time since 1982, driven by falling rents and car prices and cheaper clothing. Energy costs drove overall inflation higher, but those prices, which are set by global demand, do not pose the kind of sustained inflationary threat the Fed will meet with rate hikes.
Deflation is the real threat
Even allowing for the fact that policies which favour house buyers are driving down rents, distorting inflation data, a look at Wal-Mart's results confirms that times are tough, pricing power is rare and the real threat continues to be deflationary in nature.
Wal-Mart, which sells more to consumers than anyone, reported last week that same-store revenues fell last quarter by 1.6 per cent, driven by deflation in electronics and groceries. Wal-Mart said the influence of the "pay cheque cycle" was as strong as they have seen it.
True enough that many Wal-Mart shoppers are living pay cheque to pay cheque, but don't forget about the 16.5 per cent of the workforce which does not get a pay cheque as they cannot find work or have given up seeking it. Worse still, Wal-Mart said conditions now are more challenging still.
Clearly this is no recipe for inflation or rate hikes. It's also not very good for corporate profits, unless of course you can borrow short from the government and lend long right back to it.
So, the Fed won't tighten and US corporations will face difficult pricing conditions until downward pressure from unemployment eases.
Meanwhile in China, officials have been tightening conditions since early in the year and are quite likely to carry on. China's central bank has ordered banks to set aside more reserves and is cracking down on loans that may be used for speculation. As China is one of the principal marginal drivers of demand for everything from cement to chicken feed, this will have a cooling effect far beyond its borders, one far more powerful than the negligible impact of making the discount window a less friendly place for US banks.
Safety in government paper
Morgan Stanley equity strategist Graham Secker argues that concerns about the ability of countries to service their debt is driving up the premium investors demand to hold so-called "risk-free" government paper. Greece is a prime example of this but the real risk is not so much in Greece as in what Greece stands for – the failure of confidence in sovereigns.
Further, there is the threat that debt financing crowds out private market borrowing, a phenomenon I'd argue we are already seeing as banks choose to hold government debt rather than make business or consumer loans. Crowding out happens when government borrowing commands so much capital that private enterprise must pay more to borrow.
"Outside the government and financial sectors, the demand for credit is likely to remain low, we think, as households look to de-lever. Nevertheless, with credit availability likely to remain subdued, a rise in the 'risk-free' rate implies a higher cost of capital for all," Secker of Morgan Stanley wrote in a note to clients.
So what happens then when you combine a higher cost of capital with weak employment and widespread falling prices?
The rest of 2010 will provide the answer, but I am willing to venture a guess that it will not be higher official US interest rates, though market rates for many borrowers may be another story.
Nor, for that matter, will it be higher equity prices in most of the important markets. This feels very much like 2008 when the best people to lend to or invest in were the ones who needed it least. (Reuters)
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