Mervyn King to markets: No bail-out for you!

Calm continues to prevail as equities tread water, some CP is being rolled over (albeit at shorter maturities), and the dollar continues to tank. The buck has reached yet another significant low against both the euro and, somewhat more surprisingly, the Canadian dollar this morning. One might have thought that a severe dent to US economic growth expectations might negatively impact its neighbour to the Great White North, but for now strong energy prices, stretched resource utilization, and advantageous positioning have propelled the loony higher. It may not be long before USD/CAD shorts convene for a "parity party."

A refreshing breeze swept through financial markets yesterday, courtesy of the Bank of England. The Old Lady of Threadneedle Street has long prided itself on its market savvy and awareness, and like other major central banks it takes an active role in surveying the state of financial markets in real time.

In advance of next week's testimony before the Treasury Select Committee, BOE Governor Mervyn King released a statement setting out the Bank's views on the current state of play. The message contained therein was reminiscent of the Seinfeld Soup Nazi: "No bail-out for you!"

The entire statement, linked above, is well worth a read. But among the choicest quotes were the following:

"But the source of the problems lies not in the state of the world economy, but in a mis-pricing of risk in the financial system."

"If, in the wake of a shock to the financial system, the terms on which the financial system extends credit to the private sector become less favourable, then borrowing and overall demand would weaken. Other things being equal, that would lower the inflation outlook. Of course, other things are not equal. When the Monetary Policy Committee meets each month it reviews all the evidence on the outlook on inflation before reaching a judgment. The August Inflation Report implied that some slowdown from recent strong rates of economic growth was needed to meet the inflation target."

"the provision of such liquidity support undermines the efficient pricing of risk by providing ex post insurance for risky behaviour. That encourages excessive risk-taking, and sows the seeds of a future financial crisis. So central banks cannot sensibly entertain such operations merely to restore the status quo ante. Rather, there must be strong grounds for believing that the absence of ex post insurance would lead to economic costs on a scale sufficient to ignore the moral hazard in the future."

"If central banks underwrite any maturity transformation that threatens to damage the economy as a whole, it encourages the view that as long as a bank takes the same sort of risks that other banks are taking then it is more likely that their liquidity problems will be insured ex post by the central bank. The provision of large liquidity facilities penalises those financial institutions that sat out the dance, encourages herd behaviour and increases the intensity of future crises."

Strangely, short sterling continued its recent rally yesterday, with the March-June '08 contracts up 7-8 ticks. Markets keyed on one comment suggesting that the BOE would take the appropriate action; however, the above excerpts would strongly imply that the current mindset of the BOE is that the appropriate action is to do nothing!

What is ironic, of course, is that unlike in the US or Eurozone, monetary policy in the UK is pretty unambiguously restrictive. Markets are happily selling sterling this morning after the RICS house price balance tilted negative- could this be the real economy spillover required to prompt a BOE rate cut?
In the fullness of time, perhaps, but certainly not yet. The scope of the rollover has been modest in comparison with past episodes, and remember: it was just last month that the MPC judged that economic activity needed to slow to preclude further tightening. Now, Macro Man has disliked sterling all year, so he has sympathy for those selling it now.

But those doing so on the expectation of an imminent rate cut should be warned. The BOE is clearly not in the mood to provide a free lunch to banks and speculative turd-buyers; unlike the Fed, the Old Lady is not for turning.

Elsewhere, in the comments section to yesterday's post, reader Corey noted the confluence of factors that could produce an explosive move in gold. Now, Macro Man has avoided commodities since the disastrous GG and oil spread trades earlier this year, but has to admit that the idea has merit. Combine a weak dollar with an unneccesary provision of financial market liquidity (money markets might appear to need it, but it seems clear that other markets don't), and it would appear to be a perfect setup for a higher gold price.

Macro Man decided to run a simple study to see if these two factors have much of an explanatory power over gold, and sure enough, they do. A simple regression of y/y changes in gold with y/y changes in the DXY and global money growth yields a reasonable r^2 of 0.43. The t-stats of both factors are statistically significant.

While the model failed to identify the speculative boom in gold in late 2005, it has captured other broad trends in the yellow metal. Intriguingly, the model suggests that the gold price should be roughly 10% higher than it currently is. Projecting further decines in the DXY and rises in money growth would provide a further impetus.

While the model is obviously very, very simple (Macro Man hopes that commodity specialists have a more sophisticated analysis up their sleeves), it would appear to confirm Corey's argument and Macro Man's intuition.

It's therefore worth a punt. Macro Man will make an initial foray by buying 200 Dec 750 calls, which should cost just over ten bucks per ounce. He may well add to the position as circumstances warrant.