Wednesday, Dec 03, 2008
How much to cut tomorrow?
CityWire: Base rate tipped to match all-time low on Thursday
Some views on tomorrow's M.P.C. decision on the UK base rate.
Posted by 51ck-6-51x @ 02:28 PM (1104 views) Add Comment
21 Comments
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1. gardeniadotnet said...
Does it matter?
2. 51ck-6-51x said...
I'd err on the larger side due to the way all the economic data out there is pointing, although I would note that historically base rate changes take around one year to feed back to the real economy. As I said before the last meeting's minutes showed that the committee wanted to cut .5% more than they did, but did not want to cause panic, so 0.5% is almost locked in. They may want to cut more than they do again - for both the same reason as before and not to undermine the treasury's fiscal stimulus package (although the reasoning will be that the fiscal stimulus package means the rate cuts do not need to be so dramatic, since the MPC and treasury are meant to be independent apart from the inflation target controls).
3. 51ck-6-51x said...
gardeniadotnet.
I think it does. Don't you? If not, why not?
4. gardeniadotnet said...
2. 51ck-6-51x said...
If that was an attempt to answer my question, you failed.
5. gardeniadotnet said...
3. 51ck-6-51x
The banks are (mostly) failing to pass on the interest rate cuts. End of.
6. stillthinking said...
Banks will start lending again when house prices bottom out. The government is wrong to have delayed repossessions because they will the mark the bottom, i.e. when repossessions are no longer cost effective for the banks because the amount raised is so far off the amount owed.
When the banks give up on repossessions will be shortly before the market turns.
7. gardeniadotnet said...
6. stillthinking said... Banks will start lending again when house prices bottom out.
Banks will start lending again when the quadrillion dollar CDS market has unwound.
Which isn't going to happen.
8. fjcruiser said...
It is a conspiracy to force savers to spend their money as we all know inflation is up again cos the pound is weaker and our trade balance is negative.
9. bellwether said...
No gardeniadotnet stillthinking is right it is land/property values that matter here as they are what control credit.
The CDS market is overplayed and misunderstood I'm told. By all means explain in simple terms why they matter but my understanding is that they are nil sum ie there will be as many winners as losers.
10. gardeniadotnet said...
8. fjcruiser said...It is a conspiracy ...
Nice try. Try to mask the unpalatable truth under a conspiracy heading
11. gardeniadotnet said...
9. bellwether said... By all means explain in simple terms...
Martin Weiss did a pretty good job when describing Citigroup's plight:
The Highly Dangerous Derivatives
Derivatives are bets made mostly with borrowed money. They are bets on interest rates, bets on foreign currencies, bets on stocks, bets on corporate failures, even bets on bets. The bets are placed by banks with each other, banks with brokerage firms, brokers with hedge funds, hedge funds with banks, and more.
They are often high risk. And they are huge. According to the U.S. Comptroller of the Currency (OCC), on June 30, 2008, U.S. commercial banks held $182.1 trillion in notional value (face value) derivatives.1 And, according to the Bank of International Settlements (BIS), which produced a tally six months earlier for the entire world, the global pile-up of derivatives, including institutions in the U.S., Europe and Asia, was more than three times larger — $596 trillion.2
That was ten times the gross domestic product of the entire planet ... more than 40 times the total amount of mortgages outstanding in the United States ... nearly 60 times greater than the already-huge U.S. national debt.
Defenders of derivatives claim that these giant numbers overstate the risk. They argue that most players hedge their bets and don’t have nearly that much money at stake. True. But that isn’t the primary risk these players are taking.
To better understand how all this works, consider a gambler who goes to Las Vegas. He wants to try his luck on the roulette wheel, but he also wants to play it safe. So instead of betting on a few random numbers, he places some bets on the red, some on the black; or some on the even and some on the odd. He rarely wins more than a fraction of what he’s betting, but he rarely loses more than a fraction either. That’s similar to what banks like Citigroup do with derivatives, except for a couple of key differences:
Difference #1. They don’t bet against the house. In fact, there is no house to bet against. Instead, they bet against the equivalent of other players around the table.
Difference #2. Although they do balance their bets, they do not necessarily do so with the same player. So back to the roulette metaphor, if Citigroup bets on the red against one player, it may bet on the black against another player. Overall, its bets are balanced and hedged. But with each individual player, they’re not balanced at all.
Difference #3. As I said, the amounts are huge — millions of times larger than all of the casinos of the world put together.
Now, here are the urgent questions that, as of today, remain largely unanswered:
Question #1. What happens if there is an unexpected collapse?
Question #2. What happens if that collapse is so severe it drives some of the key players into bankruptcy?
Question #3. Most important, what happens if these players can’t pay up on their gambling debts?
This is the question I have asked here in Money and Markets month after month. Almost everyone said it was far-fetched, that I was overstating the risk. Yet, each of the hypothetical events I cited in the above three questions have now taken place in 2008.
12. Crashwatcher said...
gardeniadotnet 11 - So what you are saying is there will be loosers but for any looser there will be a winner. If theres a big looser then it stands to reason there will be some big winners to counter balance it. How will that cause me a problem?
13. bellwether said...
Thanks G but sill not that much clearer as to the risk. Bets are always 2 ways so is it not as I say (averaged out) nil sum. Also so what if some of the derivative players don't collect on their bets unless the profit had already been booked and corporate values inflated on the back of that.
Wasn't Lehmans collapse meant to cause some kind of credit default meltdown a month or so back
I think if the consumer wasn't so indebted on back of inflated house price all of this would actually be a detail
14. gardeniadotnet said...
12. bellwether said... so is it not as I say (averaged out) nil sum.
Ultimately, I imagine it is 'nil sum'. The challenge is getting there.
>I think if the consumer wasn't so indebted on back of inflated house price all of this would actually be a detail.
To my mind the reverse is true. The house price crash is a detail in the much bigger picture.
15. Pete said...
As someone who has savings (for god sake don't tell GB) I can't help but wonder how much loss of tax the treasury is getting now .... my interest has halved but so has the amount of 20% tax I pay on it.. has this been anticipated by GB. GB must be loving NS&I savers, the Premium bond owners will be lending the Government money for nothing at all soon.
I note the Queens speach wanted to 'Encourage people to save'... how the hell does Her Maj keep her face straight.
16. 51ck-6-51x said...
gardeniadotnet:
Sorry for lack of response for so long. I've been very busy at work!
1) RE: Base Rates:
As I've said before banks do not necessarily "pass on" base rate cuts - their rates are controlled by the rate at which they are able to borrow. Think about it - they borrow and lend, what does some number that is not traded have to do with that business? The base rate is not the rate at which they can borrow - it is a target rate for the spot rate which is also not traded!
A base rate is a figure for the central bank to reach - it is a goal, not an absolute - for the short end of the curve (say < 1 month). The way it is reached is through the lending done by the central bank itself.
The point of changing the rate is to attempt to pull the short end of the curve one way or the other, however it is still up to the lender and borrower (i.e. the market) to set real rates.
Tracker mortgages are set up to track the base rate - the way the lender actually achieves this is through the swaps market - they will add a spread on top of the base rate and possibly implement a collar in order to compensate for the risk that this funding becomes cumbersome.
The point of changing the rate is not to affect the mortgage market (remember the banks do not have to offer new mortgages!) - it's to affect the credit market itself, in order to encourage business.
In a nutshell:
The point of the cut is to encourage lending, in order to stimulate the economy.
2) RE Derivatives:
This kind of thing is akin to the media's reporting on the property market. I keep seeing it, and it is like propaganda - a use of fear of the misunderstood.
The total notional is not related to risk. Furthermore there is no need to argue about hedging - The vast majority (~80%) of outstanding derivatives notional is in the interest rate swaps market. When two parties enter a swap the notional is not at risk. When one of the two parties goes belly up it is the future stream of cash flows that are the default - and this could actually be beneficial to the remaining party.
If you really want to understand the real risks that the derivatives market poses register at http://www.wilmott.com/reg.cfm and ask the people who really do understand derivatives.
By the way, yes you can view a derivative position as a bet, but you can also consider any financial position as a bet - by withdrawing money from an ATM to store in your wallet you are placing a bet. Furthermore I consider all financial assets as derivatives - an equity is a derivative of a companies assets, a corporate bond is a derivative with multiple underlying zero coupon bonds, a zero coupon bond is a derivative on the spot rate (which is not even traded)... and cash & credit are a derivatives of trust.
If derivative products are wrong, then capitalism is wrong. I do not have a problem with anyone who thinks capitalism is wrong, but once one is inside a capitalist system there is nothing wrong with derivatives per se (I would concede that some structures do need regulation, that clearing houses are good things, and that new products do need to be carefully monitored with regard to use and abuse). Also I am very interested in any proposed alternatives to modern capitalism.
BTW, I won't reply to anything you post until tomorrow as I am off to a lecture on the Brace Gatarek Musiela model (BGM) now [ see: http://en.wikipedia.org/wiki/Brace-Gatarek-Musiela_model ]
17. gardeniadotnet said...
14. 51ck-6-51x
Wow, we have a real David and Goliath situation here, but we all know how that story ends.
Thanks for going to such trouble in your response - you are obviously very knowledgeable in your field. However, I don't think that is necessarily an advantage in the situation we now find ourselves.
>If derivative products are wrong, then capitalism is wrong.
Well, derivative products ARE wrong, and I look forward to a more robust defence of them by yourself in the future (you're bracketed disclaimer just won't do, I'm afraid.)
18. whostolemyendowment said...
Article from 27th Nov........Interest Rates: What Happens After Zero? http://wallstreetpit.com/interest-rates-what-happens-after-zero/
http://ftalphaville.ft.com/blog/2008/11/26/18724/the-pictorial-quantitative-easing/
19. 51ck-6-51x said...
gardeniadotnet:
You noticed, "if derivatives are wrong, capitalism is wrong" - I am not defending either (and I work at the heart of the untamed beast), just giving a better understanding and dispelling some misinformation. I am always looking for working alternatives to capitalism, I am sure one will come along one day, but replacing the current system will be extremely hard (or abrupt and hard on most people [planning4acrash style]). Please don't stop airing your views - I agree with you on many points you make, number one being that the bubble is not a housing one, but a credit one, that the cuts will happen in an attempt to keep the (credit) roundabout spinning, to have the debtors effectively bailed out by the savers. (My experience tells me that there is no conspiracy - there is no need for one.)
whostolemyendowment:
Yes, QE is happening - especially across the pond. It is true that the inflationary pressures from the credit bubble's effect on asset prices have withdrawn (look at the oil price), but in their fight against a deflationary spiral (through their attempts to keep the roundabout spinning) I fear they may go (or even have already gone) too far the other way.
20. gardeniadotnet said...
17. 51ck-6-51x said... replacing the current system will be extremely hard (or abrupt and hard on most people....
I've never considered myself a nihilist, but I really can't see an easy way out of this one. I think you may be surprised at the severity and speed of the 'downturn.'
BTW, did you learn anything significant from the LIBOR lecture?
21. 51ck-6-51x said...
gardeniadotnet:
I'd be inclined to agree. A rolling stone gathers no moss - and this stone is a boulder!
Yes, although mostly it was about the market model, BGM
- if you are mathematically minded see: http://www.math.uu.nl/people/grubisic/Thesis.pdf
- if you are not then in summary the model is a way of using liquid instruments (such as interest rate caps, swaptions and FRAs) to infer a forward rate curve in order to price derivatives of interest rates (such as derivatives of LIBOR).
I did, however, learn some hpc relevant things:
1) LIBOR (as opposed to EURIBOR) is constructed by asking banks for what they think they would be offered if they wanted to borrow, and the results are public. This has a major flaw - in times such as these a bank will not want to publicise that they don't expect to be able to get funds at the same rate as other market participant, thus the number will be lower than the reality. The lecturer (a market participant) also noted that he had recently seen traders looking for funding at 0.5% higher than they reported to LIBOR, only a couple of hours later.
2) Volatility of interest rates is not proportional to interest rates - this compares to most assets, like equity, where volatility is proportional to stock price (although still not deterministic of course) so if ABC Corp is $100 and XYZ Plc is $10, both with the same vol, the swing in ABC will be ten times the swing in XYZ. This means that at low interest rates one will observe high volatility compared to the same conditions as when there are high rates, this means that traders do not have to put on as much capital to take the same risks - this discourages borrowing for financing trades. Looking at a 1 year US swaption two years ago the vol was just over 20%, now its over 100%, this means a trade may be a fifth of the size now.