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The Bank of England Increases Its Flexibility

(August 7, 2009)

Dear Subscribers and Readers,

Known as a great debater in British Parliament and a radical politician (for his time), MP Thomas Duncombe described Nathan Rothschild – founder of the Rothschild London branch - in the following passage (one of the most colorful passages in financial history):

Master of unbounded wealth, he boasts that he is the arbiter of peace and war, and that the credit of nations depends upon his nod; his correspondents are innumerable; his couriers outrun those of sovereign princes, and absolute sovereigns; ministers of state are in his pay.  Paramount in the cabinets of continental Europe, he aspires to the domination of our own.

These words were spoken in 1828 – near the height of the Rothschild family's global power.  The Rothschild family would rule as the preeminent global banking power until the rise of the Morgan banking dynasty in the wake of the Paris Commune in 1871 and the failure of Jay Cooke & Company that precipitated the Panic of 1873.  But the strength of both the Rothschild and the Morgan banking dynasties paled compared to the power of the Medici banking family in the 15th century – a family which produced three Popes of the Catholic church and gained substantial political power in Florence in the early 15th century.

Quoting Christopher Hibbert in “The House of Medici: Its Rise and Fall” on the political power of Cosimo Medici – the first Medici to rule the republic of Florence: Aeneas Sylvius, Bishop of Siena and later Pope Pius II, said: "Political questions are settled in [Cosimo's] house. The man he chooses holds office...He it is who decides peace and war...He is king in all but name."

Indeed – as financial sophistication increased throughout the 20th century and as global wealth becomes less concentrated – the concentration of financial power has also dissipated as well.  No longer could a single financial institution hold the key to unrivaled global financial power.  As the 2008 financial crisis has so painfully demonstrated, even the all-powerful Federal Reserve had to obtain the consent and cooperation of its counterparts in Europe, Japan, China, and the UK in order to act effectively against the many liquidity crises during that time.  This is why it is important to not only track the Federal Reserve's footprints, but those of other central banks, including the Bank of Japan, the People's Bank of China, the European Central Bank, and of course, the Bank of England.

Let's begin by discussing Japan and the Bank of Japan's latest moves.  For the first time in more than 50 years, the Democrats has a good chance of winning the national election on August 30th.  If elected, the party will put an emphasis and encourage domestic consumption by putting more money in households (such as through childcare payouts and scrapping highway tolls).  Although it won't ask the Bank of Japan to monetize its debt (which is now over 170% of GDP), it is expected to work closely with the Bank of Japan should it win the election.  In the meantime, the Bank of Japan has been rather timid in expanding liquidity, as indicated by the following monthly chart showing the year-over-year growth in the Japanese monetary base, the change in the year-over-year rate of growth (the second derivative), and the year-over-year change in the Nikkei 225 Index from January 1991 to July 2009:

Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly) (January 1991 to July 2009) - The y-o-y growth in the monetary base declined from 8.2% at the end of April to just 6.1% by the end of July. On an absolute basis, the Japanese monetary base has now declined three months in a row - suggesting that liquidity conditions in Japan are no longer elevated, and confirming that the world's central banks (at least in Asia) are no longer being as accommodative as they have been during 2Q 2009.

As shown in the above chart, the year-over-year growth in the Japanese monetary base reached a five-year high of 8.2% in April.  Since then, the year-over-year growth in the Japanese monetary base has shrunk to just 6.1% at the end of July.  On an absolute basis, the Japanese monetary base has now declined three consecutive months.  However, subscribers should note that the divergence between the growth in the monetary base and the change in the Nikki Index is still close to an extreme. Assuming the Bank of Japan increases or steadies its monetary base after the election, this is still support for the Japanese stock market for the next couple of months.  The resurgence of the Japanese stock market has also been supported by strong liquidity in Asia in general – especially the aggressive expansionary policies in China, as well as the creation of the US$120 billion “crisis fund” by the 10-country ASEAN under the “Chiang Mai” initiative.

Unfortunately (or fortunately for those worried about a “bubble” in the Chinese credit market), there are some signs that the Chinese government and Chinese banks are starting to think about curbing new lending for the rest of 2009.  China Construction Bank, in particular, has vowed to cut lending by more than US$70 billion in the second half of this year. 

But fortunately for the bulls, China's financial policy isn't set in stone and should the Chinese stock market and credit market react unfavorably, there is still tremendous leeway for the government and its banks to ease monetary policy yet again.

Moreover, and more importantly for now, the Bank of England just announced its new monetary framework yesterday – and in doing so, surprising market analysts (most of whom were not expecting a shift in the Bank's quantitative easing policy) by expanding its debt monetization program from 125 billion to 175 billion pounds.  The Bank's expects to purchase an additional 50 billion pounds (or US$86 billion) of Gilts, corporate bonds, and commercial paper over the next three months.  This implies a weekly purchasing amount of about 4 billion pounds, or 60% the level it had been purchasing from March to early July when it first started its QE program.  Should the UK economy continue its decline, and should UK inflation remain below its targeted rate of 2%, I expect the Bank of England to expand its QE program later this year.  In the meantime, an additional US$86 billion in new purchases over the next three months is immensely bullish for global liquidity – and more importantly, allows the Bank of England additional flexibility in combating a slowing economy and the risk of another liquidity shock.

Finally, the latest indicators show that Federal Reserve slowed down its debt monetization program last week, purchasing only $10 billion worth of US Treasuries and agency securities for the week ending August 5th.  That is not too surprising, given the continuing strength in oil prices and in the stock/credit markets.  But more importantly, the Fed (as discussed in the latest FOMC statement) retains the option to purchase an additional $700 billion in MBS and $100 billion in agency debt by the end of this year, subject to liquidity and market needs.  This suggests that the so-called “Bernanke put” is still place, and will be utilized if the markets start to weaken again.

Signing off,

Henry To, CFA


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