While many local managers went the knee-jerk sell-off early last week, they will have ample reason today to cash up and sit on the sidelines. Despite the continuing strength of China, despite the relative solidity seen in our current June 30 reporting season, the outlook for financial markets has worsened and there is undoubtedly more bad news ahead of us.

In fact, the offshore crisis has intensified over the past couple days. There’s a definite whiff of 2008 (before Lehman Brothers failed) in the markets, rising talk of European banks finding it hard to access deposits in the US and other markets, a big European bank going to the European Central Bank and borrowing half a billion euros directly, and reports the Federal Reserve is checking the funding of European banks in the US.

Some reports have focused on this comment from Bloomberg,  which had this quote on Wednesday night from Lars Frisell, chief economist at Sweden’s financial regulator:

“It won’t take much for the interbank market to collapse. It’s not that serious at the moment but it feels like it could very easily become that way and that everything will freeze.”

For someone associated with a key regulator in Europe to be talking about a “freeze” in the key interbank market and use the word “collapse” was very scary to some in the markets.

And, the US economy is stumbling towards stalling, the political leaders of the eurozone, especially France and Germany, showed this week that they are out of touch with the current state of their economies, let alone the health of financial markets.

The ASX market today

Morgan Stanley downgraded its view of world, US and European economic growth and importantly, for Australia, says emerging Asia and China will continuing growing well above developed country levels this year and next, even if it’s a bit slower than earlier forecasts.

So watch the Reserve Bank’s September 6 meeting for a possible rate cut, especially if the funding strains in European banking deepen. Before then deputy governor, Ric Battellino is due to speak in Sydney next Tuesday and will no doubt be pressed on the possible RBA reaction to the strains continuing to concern markets.

The RBA is worried indeed about Europe; the minutes of the RBA’s August 2 meeting released this week showed quite clearly it was growing concern inside the bank about the financial problems in Europe that helped stave off a rate rise this month.

Adding to these strains is the declining health of the US economy. Fed chairman, Ben Bernanke is due to speak at a central bankers talk fest next Friday night, our time (The same one where he announced the second round of quantitative easing last year). He might not be able to do much, but will say a lot though. The US economy is slowing quite noticeably.

Overnight, US unemployment weekly benefit recipients rose unexpectedly back above the 400,000 level: they have been falling for the past month, sales of existing homes fell sharply when they were forecast to rise in July. And most crucially of all, a survey from the Fed of manufacturing in the Philadelphia area shocked with a huge fall back to the levels in the 2008 recession. That followed the monthly survey from the Fed for the New York area on Monday night, which again was weak.

Both surveys showed a sharp fall in new orders in the past month: the reading for the Philie survey is normally associated with recessions, which triggered the huge sell-off on Wall Street. Gold, of course, rose to yet another record, the Aussie dollar fell as risk-averse investing returned to markets, and oil fell.

US consumer price inflation came in higher than expected in July at 0.5% for the month: that took the headline rate for the year to July to a nasty 3.6%, which would have spooked markets and sent bond yields racing higher, but there was so much demand for the recently down-0rated securities, that yields plunged to all-time lows. Core inflation hit an annual 1.8%, up from 0.8% at the end of December. Despite what some might think, rising inflation is better at the moment than disinflation, which could easily turn into a nasty bout of deflation.

While a lot of people still believe the US and Europe can have an economic slide on their own and not hurt Australia because of the faster growth in emerging markets, the grim fact is that a recession in the US is bad news for stock markets everywhere.

Strongly growing China might take the edge of a slump (many markets are in a correction or bear phase already) for Australian markets and the economy, but it won’t stop us feeling some impact.

And, most important of all, there’s a whiff of a freeze in the air in the banking markets, and I don’t mean the early onset of the northern autumn. No, it’s a growing fear that lending markets are starting to gum up, a very worrying development given that the world economy is awash with cash searching for a home.

That need for safety and liquidity saw bond yields in Germany, the UK and downgraded America hit historic lows overnight: the yield on the US 10-year bond rate finished at 2.08%, but during trading fell under 2% for the first time in 60 years or more, touching 1.97%.

That is lower than the lows seen in the GFC in late 2008 and early 2009.

But why this fear about the European banks and French banks in particular? It’s not that there’s a shortage of cash, it’s there and banks finding it hard to get money can always ask their central bank for help, as one European bank did last week when it did a €500 million “repo”.

That news broke earlier this week, to be followed by reports in The Wall Street Journal that the US Federal Reserve’s New York branch (the one that does all the market dealings with banks), was checking on the funding of European banks in the US to make sure they have enough and that money isn’t being sent back to their head offices.

That got blood racing in financial markets in Europe and when the weak economic news from the US hit the wires about midday (in Europe), weak markets turned into plunging markets: falls of more than 4% to more than 6% were reported from London, Germany, Italy and France.

The ECB has also been supporting Greek, Irish, Spanish, Portuguese and lately, Italian banks by lending them money on a month-to-month basis. That’s in addition to the buying of sovereign bonds from Greece, Spain. Italy and other countries.

But from market chat and commentary, there’s a definite trend of US dollars being recalled to the US and euro investors heading for Switzerland, draining liquidity and readily available funding out of Europe.

The US Fed can combat this, as it did in late 2008 and early 2009 by doing US dollar swaps with central banks, such as the ECB, the Bank of England and the central banks of Japan, Switzerland and Sweden to maintain supplies of greenbacks (essential for trade financing and settlements) in European markets; but if it does that, its an acknowledgement that the situation is very serious and a funding freeze is taking over.

Stand by. If the Fed announces currency swaps, you know it is 2008 redux. So who or what will be the Lehman Brothers of 2011?

Peter Fray

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