Tuesday 19 January 2010

The Coming Crash of 2010

There is now a significant and growing threat of a second economic crash in 2010. Most major western countries are recording record budget deficits this year in an attempt to provide financial support to their economies. The US, for instance, is set for a $ 1.5 trillion deficit; the UK is heading for a 12% deficit, or perhaps UKP 180 bln. Unemployment is growing in most countries: public spending may have to rise further.

At the same time, most Central Banks having announced the end of Quantitative Easing (QE), the practice by which Central Banks buy mortgage-backed debt or government bonds, or provide low-cost loans to the banking sector. According to Morgan Stanley, the US Federal Reserve spent $ 1.6 trillion to buy US Treasuries least year, while the Financial Times reports that the Fed purchased an additional $ 1.25 trillion in mortgage-backed securities. The Fed has announced the end of QE in March.

The European Central Bank has engaged in much more limited QE in terms of bond purchases, but has opened over EUR 1 trillion in bank refinancing at the 1% (or less) window rate. It is now winding down this credit facility. The Bank of England has already bought UKP 200 bln of government bonds, but has announced the end of its QE programme in February.

Most economic growth recorded in QIII 2009 was due to government stimulus. Incentives such as the “cash for clunkers” vehicle scrappage schemes; various government bail-outs of banks or industrial firms; and higher rates of investment in public works dominated growth. In QIV 2009, in contrast, there was limited private sector growth as firms re-built inventories in anticipation of the Christmas sales season. Governments, of course, continued their stimulus packages.

Where does that leave us in QI 2010?

• Unemployment is growing;
• The US government continues to disburse its original $ 780 bln stimulus package, but requires $ 1.5 trillion in loans to cover its budget deficit;
• Growth in Europe is anemic or declining in the private sector;
• European government spending continues to grow: most deficits are expected to peak this year in Europe.

As net exporters, it’s clear that the Asian economies will not be able to generate sufficient demand to fuel economic growth in Europe. If anything, the chances of a crash in China are higher in 2010, as the $ 2 trillion loan binge ordered by their government comes to an end.

If Quantitative Easing ends as announced, there is no way most western governments will be able to finance their deficits using open markets. Sovereign wealth funds (such as China’s or Abu Dhabi’s) may be able to make up some of the shortfall, but I doubt this would be more than 30-40% of funding requirements. Given China’s own instability, I’m not sure how much more of its forex reserves it's willing to bet on US debt.

Conclusion: we will probably (55-65% probability) see a rapid contagion in sovereign debt markets by March or April 2010 if QE ends and governments are forced to rely on the open market for funding. Public sector debt will crowd out private sector issues, exacerbating the existing liquidity crisis and leading to a renewed “flight” to alternative asset classes (such as gold) or to “safe havens” as the panic spreads. For smaller, exposed markets such as Greece, Ireland or Spain, this contagion will constitute a major barrier to future debt issues. This will lead to the need for the ECB or larger European countries such as Germany to buy or guarantee this debt, changing for good the rules of the game.

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