Central Banks Other Option, Crossing the Rubicon

Interest-Rates / Credit Crisis 2008 Feb 14, 2008 - 12:35 PM GMT

Rubicon ( Rubicō , Italian: Rubicone ) is a 29km long river in northern Italy. The river flows from the Appennines to the Adriatic sea through the southern Emilia-Romagna region between the towns of Rimini and Cesena. The river is notable as Roman law forbade its generals from crossing it with an army. The river was considered to mark the boundary between the Roman province of Cisalpine Gaul to the north and Italy proper to the south; the law thus protected the republic from internal military threat. When Julius Caesar crossed the Rubicon in 49 BC, supposedly on January 10 of the Roman calendar, to make his way to Rome he broke that law and made armed conflict inevitable. According to Suetonius he uttered the famous phrase ālea iacta est ("the die is cast").[2]

Suetonius also described how Caesar was apparently still undecided as he approached the river, and the author gave credit for the actual moment of crossing to a supernatural apparition. The phrase "crossing the Rubicon" has survived to refer to any people committing themselves irrevocably to a risky and revolutionary course of action – similar to the current phrase "passing the point of no return". It also refers, in limited usage, to its plainer meaning of using military power in a non-receptive homeland.” Wikipedia.com

This week ,we saw a .3% rise in US consumer spending, news that boosted US and foreign markets. Gold held $900 strongly, and the USD weakened slightly. Every time we see any indication of better US economic stats, even this small US consumer number, we see immediate bullish reactions for world stocks.

The reason is that markets holding onto bullish hopes are closely following and looking for any rebound in US consumer spending. Here is the dilemma the Central banks are looking at:

Latest credit disaster

With credit markets frozen, the only hope of economic recovery is a rebound on the demand side of the economy. Lowering interest rates in a falling demand environment has not been working to loosen credit markets much. As more credit markets catch the flue (US Bond Auctions for municipals and such, $25 billion a day roll over, are now frozen, with BoA just announcing that 80% failed to roll over Feb 13, sending yields to nosebleed levels. These are 20 to 30 day short term money. If holders of these cannot sell they have to hold them.)

“Auctions of bonds sold by cities, hospitals and student loan agencies are failing as confidence in the creditworthiness of insurers backing the securities wanes, and as loss-plagued banks seek to avoid tying up their capital. More than 129 auctions failed yesterday, said Anne Kritzmire, a managing director for closed-end funds at Nuveen Investments in Chicago.” Bloomberg

Liquidity trap

Now, some credit markets have loosened since the US Fed cut interest rates recently. But, 30 yr mortgages are running 5.64% vs 5.82 a year ago, barely dropping, in spite of a 2.25% in total Fed cuts since a year ago. The Fed target rate is now 3% vs 5.25% a year ago.

So far, CB interest rate cuts are not finding their way into credit markets much. The only way CB rate cuts can work is if lenders are willing to lend, and that is where the problem lies. Lenders are sitting on their hands, meaning that CBs are facing a classic liquidity trap. (CBs are willing to lend and cut rates, but lenders trap that liquidity and won't lend).

US consumer recovery is only hope for world financial markets

Hence, we see the reaction this week, as a mere .3% rise in consumer spending provides a sliver of hope to stock bulls. The only hope of restoring confidence to financial markets is if there is a demand driven economic turnaround. If it's rate cutting alone, that seems to fall flat in the liquidity trap. Hence, the ecstatic reaction to the slim .3% rise in consumer spending this week.

I think that stock reaction to that data is more hope than substance. Since our US consumer economy is credit driven, and credit is having a heart attack across many sectors, and US rate cuts thus far have had minimal effects, the prospects of any meaningful demand driven recovery in the US is just about nil.

Nevertheless, hope springs eternal, and the US and Asian stocks rallied quite a bit on that consumer news.

But, the fundamental problem, contracting credit, is still very much with us, as we just pointed out on the now frozen market for auction rate securities. UBS just stated they do not intend to carry that market (bidding to keep liquidity in it), and other banks have also stopped bidding.

CB's Rubicon

So, even as CBs continue to cut, so far quite a bit of US cutting has had little real effect. With US target rates cut from 5.25% vs 3% now, both consumer and corporate credit have not eased. It is said the US Fed needs to cut to the 2 year bond rate to have any chance of loosening US credit markets – which would be around 2%. The Fed is still behind the curve.

In fact, looking at credit markets now, it looks as if the Fed is not only behind the curve, but has let the train get completely away from them. If they have any hope of catching it, they need a target rate of 2% now. But inflation is still a concern, and that is not going to happen in time.

The other option, Crossing the Rubicon

A while ago I wrote a piece that, if markets got bad enough, central banks could be faced with having to monetize all the bad assets accumulating on financial institutions books. That would be the only way to get banks lending again, and to put a floor on markets.

If CBs saw that interest cuts failed to restart US consumer spending, they would then be faced with the option of actually buying everything in sight to support financial markets. This is monetization of markets. (Monetization is where central banks merely buy everything in sight where the losses are and hold it on their own balance sheets. Presently, central banks are doing what are called REPOs, repurchase agreements, which are short term CB purchases of assets that are supposed to be bought back and the money repaid by the seller. This is short term central bank purchasing of assets, but is not actual monetization, as the assets are only held for a month or so. Monetization would be just wholesale purchases and holding of troubled assets, and no Repo agreement.)

Gold here

With Central banks lowering interest rates, and more to come, gold is rising in all major currencies. This will continue in 08, sans some major world stock crash. But, if central banks actually do the other option, monetization of troubled assets and markets, and cross the Rubicon, then gold will go right out of sight. Even a hint of any serious monetization would drive gold rapidly to $2000.

If we merely have interest rate cuts, gold will get easily over $1000 in 08, probably in a month or two. If there is any significant monetization by Central Banks (perhaps just buying outright all the troubled assets on banks books, right now about $2trilllion worth and counting) gold goes to over $2000 in a few months time.

Monetization is the central bank's Rubicon. They are thinking of crossing it. We are at a decisive point in gold's price action in 08.

By Christopher Laird
PrudentSquirrel.com

Chris Laird has been an Oracle systems engineer, database administrator, and math teacher. He has a BS in mathematics from UCLA and is a certified Oracle database administrator. He has been an avid follower of financial news since childhood. His father is Jere Laird, former business editor of KNX news AM 1070, Los Angeles (ret). He has grown up immersed in financial news. His Grandmother was Alice Widener, publisher of USA magazine in the 60's to 80's, a newsletter that covered many of the topics you find today at the preeminent gold sites. Chris is the publisher of the Prudent Squirrel newsletter, an economic and gold commentary.

Christopher Laird Archive

Comments

John Ryskamp
14 Feb 08, 13:35

Monetization

You leave one step out of the monetization process: social policy determination. One example will suffice: if Central Banks buy bad mortgage bonds, do residents remain in the housing or not.

All of these financial decisions have political ramifications. If you are talking about monetization, you are talking about fundamental Constitutional policy, both here and abroad--around the world, really.

For this reason, your readers may want to know that, yes indeed, we are undergoing a Constitutional regime change, and it is being forced by suburbia, terrified of losing housing, medical care and any other important fact you might care to name.

This should not come as a surprise. In fact, you might want to read Prof. G. Edward White's (University of Virginia law school) online essay, "Historicizing Judicial Scrutiny." We get a Constitutional regime change about every seventy years. Here's what the new one looks like:

Since West Coast Hotel v. Parrish (1937), policy has passed Court scrutiny as long as it was "rationally related to a legitimate government purpose." This was interpreted by the political system as conferring on the system, vast discretion with respect to facts.

However, where there are no individually enforceable rights with respect to any of the facts (for example, no right to housing--Lindsey v. Normet) and no commitment to maintain any facts, such as housing--the "scrutiny regime" contained the seeds of its own failure, because it was simply a prescription for corruption.

Now suburbia feels the threat, and wants to take many facts entirely out of the political system, giving absolute power over them, to individuals. It wants the "maintenance regime," the chief tenet of which is that policy is Constitutional only if it maintains important facts.

This, as you can see, eliminates almost all political discretion with respect to spending. It is not so much that the financial system is going bankrupt right now. What is happening is that all the money is being sucked out of the scrutiny regime and being transferred to the maintenance regime.

But in the meantime, you get failures of auctions of bonds for such scrutiny regime policies as hospitals and ports. This is a signal that support for the scrutiny regime has collapsed.

What follows is a Constitutional crisis. You will see this emerging within the next few months. It will, of course, have an utterly disastrous impact on the economy and on markets, because it will mean there is no central authority--no authority, period. A dangerous era, no doubt.

If you want to see how public opinion is changing Constitutional regimes, I study it in the context of the response to the Kelo decision on eminent domain. Eminent domain is, of course, the sine qua non of scrutiny regime policies. If it is challenged, the whole power structure of the U.S. is destroyed. John Ryskamp, The Eminent Domain Revolt, New York: Algora, 2006.

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