Posts Tagged ‘credit crisis’

When will the next bull market for commodities arrive?

Tuesday, May 12th, 2009

Following from what we wrote at Does the major Chinese economic slowdown signify the end of the commodities boom?, what is our view on the long-term prices of commodities? To understand our view, you will have to follow our explanations below…

No doubt, the global financial markets have experienced a serious bout of price deflation for financial assets and commodities (except US Treasury bonds), especially in the second half of 2008. So far, government stimulus, bailouts, rescues and money printing are minuscule compared to the overwhelming tide of de-leveraging. It has been said that a value of US$33 trillion was wiped out from the global financial markets. So far, government interventions had only forked out at around a few trillions of dollars at most. These numbers are not meant to be accurate, so please do not quote us on that. The point is, compared to the amount of ‘wealth’ lost in the financial asset markets, government injections of money so far are just a small fraction of what was lost. If you include the coming de-leveraging by consumers in the real-economy, then the outlook for the economy and asset prices is even bleaker. Having said that, if governments continue to inject even more money unceasingly, it’s only a matter of time reflation will occur. Indeed, the current rally in commodities and stock prices shows that reflation is working for now.

So, while asset (and commodity) prices are deflating at such unprecedented speed, what will happen to real physical investments in the real economy? Such volatility in prices will make it very difficult for businesses to engage in long-term real capital investments. Using the mining executive as an example in Real economy suffers while financial markets stuff around with prices,

For example, place yourself in the position of a mining company executive today. Commodity prices are falling precipitously over the past few months as the global economy is staring into a possible depression. At the same time, you know that China and India is still going to demand lots of commodities in the very long run in the coming decades. Besides knowing these two basic facts, there will still be great uncertainty in prices as the forces of deflation and inflation battles each other for supremacy, regardless of which forces will eventually win. Will we even be using US dollars to calibrate prices in the future? Who knows? In such an indeterminate environment, it is clear that many more mining projects will have to be shelved. Some have to be abandoned. You may be scratching your head, wondering whether to push forward your project plans.

As we have already seen in various news reports, mining companies are already losing mining, closing down their mines, laying off staffs, cutting production and so on. These will result in lower productive capacity in the long-term. Since the mining business is very capital intensive, it is not easy to ramp up production at a flick of the switch.

Now, let’s turn our eyes at China. As we explained before in Does the major Chinese economic slowdown signify the end of the commodities boom?, a major economic correction for China does not spell the end of Chinese economic growth. Eventually, they will recover and consume resources hungrily again (see Example of a secular trend- commodities and the upcoming rise of a potential superpower).

The question is, when will China recover? Will it happen within our life-time? Some reckon it’s a matter of waiting a couple of years. Others are more sceptical. But let’s assume that a Chinese recovery will happen in a few years time. At the same time, with the long-term productive capacity of mining companies severely impaired by the effects of the credit crunch, what will happen to commodity prices?

Please note that this does NOT mean that commodity prices will surge soon. Rather, this credit crisis is setting the stage for a new commodity bull market from a very low base. The question is, are the current prices near the low base? Or is there more deflation in prices to come?

Can falling interest rates and rising mortgage rate come together?

Monday, July 21st, 2008

Yesterday, in Too eager for an interest rate cut?, we said that

Fourth, an interest rate cut by the RBA need not necessary mean a cut in the mortgage rate. In fact, the opposite can occur.

Today, we will elaborate on that.

A large fraction of Australia’s borrowed money is sourced from overseas through the ‘shadow’ banking system. In other words, there are not enough domestic deposits to fund all the needed credit (e.g. home loans) in this country. As we explained before in Rising price of money through the demise of ?shadow? banking system, with the fall of the ‘shadow’ banking system, the supply of credit shrinks. This resulted in a rise in the price of money.

That is why non-bank mortgage lenders (e.g. RAMS) found their business in trouble. Because they are not banks, they do not have access to deposits to fund their lending. Their only source of funding is through the ‘shadow’ banking system. When money from that system dried up (i.e. credit crisis), they could no longer lend money as cheaply as before.

The banks, on the other hand, are not left off the hook. Because of their deposit base, they are in a better to weather the credit crisis storm. But overall, there is still a shortfall of deposits to provide for all the demand for lending. As the de-leveraging of the global financial system continues, the price of money will continue to increase. This left the banks with two choices:

  1. Increase the cost of loans (e.g. mortgage rate).
  2. Attract more deposits with higher interest rates- that’s where all the attractive term deposit interest rates from the banks come from.

For Australia to be completely free from the ‘shadow’ banking system, two things must happen:

  1. Borrowing must decrease.
  2. Savings must increase.

This is the only way to bridge the gap left by the credit crisis in the absence of any central bank intervention. We believe that the credit crisis will worsen (see Is the credit crisis the end of the beginning?), which means the gap will widen, which in turn implies even higher lending rate. Since the Australian economy is very much addicted to credit to keep going, any dramatic fall in its supply will have serious repercussions. What to do if such a day eventuate?

Not to worry, because Australia has a central bank (note: sarcasm here)! Since the Reserve Bank of Australia (RBA) is the only institution that can create credit out of thin air, we can be sure they will cut interest rates and be the lender of last resort when the day of reckoning comes. But that does not necessarily mean that mortgage rate will come down too, as reported in this news article, RBA rate cuts may fail to ease mortgage pain,

National Australia Bank chief economist Alan Oster, just back from a month in Europe, said a reprise of the British experience, where banks failed to ease the burden on borrowers despite official rates falling 75 basis points over six months, was not out of the question.

Is it a liquidity or solvency crisis?

Monday, May 5th, 2008

As you would have read by now, Warren Buffett declared that

The worst of the crisis in Wall Street is over. In terms of people with individual mortgages, there’s a lot of pain left to come.

As this Bloomberg article, Buffett Says Credit Crisis Ebbs for Wall Street Firms (Update4), reported,

Warren Buffett, chief executive officer of Berkshire Hathaway Inc., said the global credit crunch has eased for bankers, and the Federal Reserve probably averted more failures by helping to rescue Bear Stearns Cos.

Clearly, the market is in agreement with Warren Buffett, with the stock market rallying in the belief that the worst of the credit crisis is over. So, could the credit crisis be just a liquidity problem? Or is it a more serious solvency issue? What is the difference between the two?

Well, let’s use the pawnshop analogy from our previous article, Central banks and pawnshops. Let’s suppose that Tom had a big mortgage debt, recurring bills to pay and a nice well-paying job and no savings. Let’s say he resigned from his job to take up another well-paying job. The only catch is that in between these two jobs, there was a period of 2 months where he would draw no wages. Since he had no savings, this will mean that he would be unable to pay his bills and his mortgage debt repayments. Not to worry, Tom went to the pawnshop and pawned his gold jewellery for cash to pay his bills and mortgage debt. Then when his new job starts, he will draw out his salary to repay his loan from the pawnshop and redeem his gold jewellery. Tom had a liquidity problem. Fine.

What if, Tom was retrenched from his job and for the next 12 months, could not find another job? He could pawn his gold jewellery, but as long as he did not have a job, he would not have any hope of repaying his loan from the pawnshop in order to redeem his gold jewellery. The next month arrived and he had to pay that month’s bills and mortgage repayment while his gold jewellery was still stuck at the pawnshop. Tom is getting more desperate. Perhaps he can pawn his silver jewellery? Fortunately, the pawnshop was as willing as the Fed. It accepted Tom’s silver jewellery for the same amount of cash as the previous loan. Tom was saved for another month. Obviously, Tom had a solvency problem. That’s bad.

So, is the credit crisis a liquidity or solvency issue?