Credit crunch worsens after Britain cuts interest rates - 7-Dec-07 - Generational Dynamics

Financial pundits are wondering, this Friday morning, why the international credit markets have gotten worse, instead of better, after the Bank of England cut overnight interest rates on the British pound a quarter point to 5˝% from 5ľ%.

The BoE's Bank rate is similar to the American Fed Funds Rate. It specifies the overnight interest rate -- the rate at which banks lend money to each other for just one day.

The problem that policy makers are facing is that normally one wants to borrow money for a longer period than one day -- with three months being a typical time period. And the three-month borrowing rate is determined by the marketplace, not by the BoE bank rate or the Fed funds rate.

Nonetheless, the different rates usually change in unison. When a central bank (the BoE or the Fed) reduces the overnight rate by 25 bp (= 25 basis points = 0.25% = Ľ%), then it's normal for the 3-month lending rate also to fall by 25 basis points.

The BoE lowered overnight interest rates by 25 basis points, but the 3-month rate fell by only 4 basis points. This indicates that banks are still hoarding money, as I described in "Questions and answers about the 'credit crunch.'"

The Bank of England's stated purpose in lowering the overnight rate was to bring down 3-month rates, but they failed to do so. The 3-month rate was an extremely high 6.65% before Thursday, but on Friday it's almost as high at 6.61%.

The 3-month rate is known as Libor, or the London Interbank Offering Rate. This is a market-driven rate, and it's different for every currency (dollars, pounds, euros, etc.), and it's different for every time period (overnight, 3-month, 6-month, etc.).

The overnight rate is sometimes referred to as the "overnight interest swap," or OIS. This market-driven value is different for every currency, and it usually equals the overnight fund rate for the central bank. Thus, you can think of the OIS as a proxy for the Fed Funds rate in dollars, for the BoE bank rate in pounds, or the European Central Bank rate for euros.

The "spread" is the difference between the official bank rate and the market-driven rate for whatever interest rates we're talking about.

In this case, we're talking about overnight rates for the pound, versus the 3-month Libor rate for the pound. As we said, those rates are 5.5% and 6.61%, respectively. The difference between these two values (1.11% in this case) is called the "spread." A spread of 1.11% is exceptionally high.

This situation is so exceptional that some UK economists are saying that the "Bank of England has lost control" of monetary policy, and that it can no longer do anything but react and hope for the best:

"Experts warned that it was a sign that the credit crisis could escalate over the Christmas period, even though the Bank has now embarked on a major series of interest rate cuts for the first time in almost eight years.

It coincided with a chilling warning from the Organisation for Economic Co-operation and Development that the UK economy is heading for a major slowdown next year - and possibly a "significant slump" in house prices.

This month's short sterling futures, which indicate where the market expects the key benchmark interbank borrowing rate to be in two weeks' time, actually rose markedly after the Bank's decision - an almost unprecedented reaction. The pound also ended the day up slightly on its trade-weighted index - another highly unusual outcome on the day of an interest rate cut.

John Wraith of Royal Bank of Scotland said: "They haven't got the control over rates in the financial system that they ordinarily have.

"Historically, a 25-basis point change in Bank rate would lead to an almost identical change in Libor [the benchmark rate in the money market]. That hasn't happened." ...

Peter Spencer, chief economic adviser to the Ernst & Young Item Club, said: "The fact of the matter is that the market rather than the Bank is now dictating monetary policy - and not from the point of view of controlling inflation, but from the point of view of a random walk. It is behaving in a way which is totally rational for individual banks but adds up to a major deflationary issue.

"I think this is a very grave situation indeed - and not just for the 1.5m [households due to renew their mortgages next year]. If this problem is not sorted out in the next two to three months we are looking at major insolvencies in UK plc."

The sense of fear in the City was compounded by the severity of the Bank's brief accompanying statement, which said: "Conditions in financial markets have deteriorated and a tightening in the supply of credit to households and businesses is in train, posing downside risks to the outlook for both output and inflation further ahead."

The situation is puzzling economists, as in this article entitled "Why is the LIBOR differential getting larger?" accompanied by the following graph:

3-month Libor rates versus overnight rates (OIS) for UK pounds sterling, euros, and US dollars (Source: mi2g.com)

The above graph shows the overnight vs 3-month interest rate spreads over the last four years in bps (basis point spread).

As you can see, the spreads are normally around 5-10 basis points, or around 0.05% to 0.1%.

However, there was a huge spike in August, giving rise to the international "credit crunch" that almost caused a market meltdown.

That's why the credit crunch is more serious today than it was in August, and why UK economists are saying that the BoE has "lost control" of monetary policy.

This follows several recent warnings by the Governor of the BoE, Mervyn King, that the worldwide financial markets are poised for a crisis.

Over here in America, where most investors probably wouldn't even know how to spell 'UK', the concerns of the Bank of England are out of sight, out of mind, and investors are continuing their drunken orgies, especially now that the Treasury Dept. has announced its bailout plan to "save struggling homeowners."

I haven't studied this plan enough to see if it makes sense, but I note that pundits and politicians are quite mixed about it. Many pundits believe that at best it will do nothing and at worst it will do more harm than good. Other pundits think it's wonderful. And now the politicians are getting into the act, which can only be a bad thing, led by Hillary Clinton who's saying that "it doesn't save enough people." Yecch.

My own view is that you should remember that the government is being run by Boomers who have no governing skills, and the Democrats are being driven by nihilistic Generation-Xers in Moveon.org. These are the people who probably couldn't even spell 'UK', and so it's doubtful that they have any idea what's going on in financial markets, which is just as well.

From the point of view of Generational Dynamics, none of this makes any difference. The spike in interest rates is being caused by the fact that there's much less money in the world than there was a few weeks ago, and there's less and less every day.

What we're really seeing is a massive adjustment in generational attitudes. Boomers and Gen-Xers have been blithely and contemptuously abusing the credit markets in a debauched fashion, thinking that someone else will pay for their mistakes. They believe that a massive stock market panic and crash is impossible, or at worst, inconsequential. From the point of view of Generational Dynamics, such a panic and crash is certain, and it will be disastrous, as the Boomers and Xers will learn. (7-Dec-07) Permanent Link
Receive daily World View columns by e-mail
Donate to Generational Dynamics via PayPal

Generational Dynamics Web Log for 7-Dec-07
Credit crunch worsens after Britain cuts interest rates

Web Log Pages

	Generational Dynamics
	Forecasting America's Destiny ... and the World's

\| HOME \| WEB LOG \| COUNTRY WIKI \| COMMENT \| FORUM \| DOWNLOADS \| ABOUT \|

Generational Dynamics Web Log for 7-Dec-07 Credit crunch worsens after Britain cuts interest rates

Web Log Pages

Generational Dynamics Web Log for 7-Dec-07
Credit crunch worsens after Britain cuts interest rates