Page last updated at 12:24 GMT, Thursday, 4 June 2009 13:24 UK

City Diaries: 4 June

Man looking at a falling graph

These diaries are written by people who work in finance and have had a front row seat as their industry goes through the biggest changes in decades.

They give us regular insiders' updates on the mood in the City of London and the dramatic changes in the world of finance.


"Stephen" (not his real name) has worked in the City of London for over a decade.

N Korean military officers celebrate the nuclear test at Pyongyang Indoor Stadium on 26 May (KCNA)
Stephen says the threat of nuclear conflict registers barely a blip

Most traders close to the action are struggling to overcome their bafflement at what has unfolded since March. The market's eerie upsurge defies all rational explanations.

Earnings have been shredded, North Korea waves nuclear bombs at its neighbours, Pakistan threatens to implode and, closer to home, there are no obvious drivers for a new round of growth or job creation.

The news is awful, but nobody sells. The threat of nuclear conflict in the Korean peninsula registers barely a blip. But the market grinds higher, and nobody cares.

Most of what sounds like good news is merely speculation about "green shoots". Newspapers seize upon whispers that house-prices are "rebounding" and these whispers risk turning into beliefs. But why should house prices be rising and where is the money to pay those still-high prices going to come from?

Around 600,000 Americans have been losing their jobs each month since Obama was elected. And now nearly 10% of American mortgages are default. The proportions are equivalent, if not worse, here in the UK.

Traders look on, baffled by the news reports even more than by the rally. Who is coming up with these reports, where do they get their ideas from and which data give them hope that things are improving? Are they aware of the dangers of false hope?

Bond 'crash'

Those traders who still have jobs are happy to have them. In their determination not to make a wrong bet, nobody is taking on risk

Which lender, whether in receipt of government funds or not, would believe in "green shoots" when faced with a looming threat that might make the subprime crisis look like the warm up?

Between 2004 to 2007, many home-owners apparently logged Mr Greenspan's endorsement of "financial innovation" and took out mortgages with exotic names such as Option ARM. Many such mortgages had five-year terms and these will expire in various waves in the next three years, requiring a replacement. The interest rates at which these will reset depends on the bond market.

Whilst not widely reported in the regular news, the bond markets had a mini crash in May. There's even talk of the ending of the multi-decade bull market - a market characterised by rising prices - in bonds.

The bond market dwarfs the stock market. It's also generally considered to be more boring. But this market determines the price of long-term credit. Crashing bonds mean higher mortgage rates just as millions of mortgages are going to reset.

The risk is this: millions of home-owners who are already financially stretched will be pushed to breaking point once their mortgage resets, triggering another spiral of defaults, repossessions, write-downs, implosions and lay-offs.

Despite this economic outlook, the stock markets in the last three months have agreed with the unstated assumptions in the whispers of "green shoots" - that growth is a prerogative of the modern era, that rebounds are always V-shaped and that central banks and politicians have abolished the business cycle that has plagued economic life since ancient times.

The rally we've seen is almost without peer in financial history. Day by day, week by week, the rally ground higher yet it displayed few of the qualities that generally mark the beginning of a new bull market, if any. It's been a low-quality bounce that slowly dismembered the bears but failed to create new bulls. Financial historians point to 1937 as a rough parallel but it's an inexact one and, despite one of the greatest stock market rallies ever, few traders came out on the right side of it.

The ways of this bear market (a market characterised by falling prices) mightier than almost any in living memory, are difficult and paradoxical.

Those traders who still have jobs are happy to have them. In their determination not to make a wrong bet, nobody is taking on risk. This basically undermines the point of employing them.

Even if we do not see another round of mortgage crises, it's rational to fear more closures and lay-offs in the financial sector, boding ill for London and the wider economy.


Anthony (not his real name) works for an investment bank in the City.

A Hummer and a Cadillac at a General Motors dealership in Burlingame, California
The City focuses on tangible events like the collapse of GM, says Anthony

There is a book called The Black Swan by Nassim Taleb which discusses in some detail the impact of the highly improbable. 9/11 was a Black Swan event because nobody predicted it. The book's argument is that the impact of these random events will have a major effect on our lives.

It is these events that we should look out for. Trying to predict when we will emerge from recession is not important. In the end nobody knows least of all City forecasters.

Events in the world such as the underground nuclear test and firing of missiles by North Korea is a potential Black Swan event, but for some curious reason, the City have ignored it. Clearly, if North Korea moves from a test to a nuclear engagement then the Black Swan event would have occurred and the markets would literally fall off a cliff. But nobody seems that concerned about this in the financial markets.

Instead, the City prefers to focus on more tangible events such as the collapse of General Motors. This is something it understands and in economic terms, it is on par with the demise of Lehman Brothers. It was not a Black Swan event and was very predictable as the car industry has had excess capacity for many years.

The message in the City is that the car industry must contract and if workers in Luton suffer because the prospects for the Vauxhall brand are inferior to Opel in Germany, then so be it. It's a simple law of the market, but not one I share.

Unfortunately, I am just as bad as the other forecasters because it is events such as this which has made me argue in earlier diaries that talk about "green shoots" are premature.

I am an advocate of the double-dip recession - a so called "W" recovery, where there is a steep fall, followed by a steep recovery and then another fall before another recovery finally appears which becomes more sustained. I suppose my pessimism is because I know the City will always want to talk up a recovery and therefore take all this optimism with a pinch of salt. The reason for the optimism is simple. If there are more buyers, the City will make more money as volumes go up as punters become convinced that they cannot lose money on the markets.

But it seems that investors do not share that level of optimism. A study by Barclays Capital published this week reports that most investors are sceptical about this rally being sustainable. Investors are not interested in MP expenses. What they have noticed is rising bond yields reflecting market concerns about how governments will finance the huge debts that are being run up with toxic asset purchases and quantitative easing.

I am an advocate of the double dip recession - a so called 'W' recovery where there is a steep fall, followed by a steep recovery and then another fall before another recovery finally appears which becomes more sustained.

And Gordon Brown has time to phone Simon Cowell to enquire whether Susan Boyle is OK. It seems that concerns about the economy are taking back stage. But I am afraid Rome is still burning.

My colleagues therefore remain cautiously optimistic if nobody else does. Alan Clarke, an economist at BNP Paribas says that an improvement is unsurprising. He says: 'We have had such a huge contraction that when the cogs start whirring again then by definition output has started to expand.'

My concern is that the "cogs will start whirring" in Asia and not in the US and European economies. We have to face up to the simple fact that there is a major shift underway in the balance of economic power from Western to Asian economies. "Go East, young man" is what the City really feels at the moment. And if there is money to be made, the City big hitters will be there.

If we regulate and tax these guys out of London, then "goodbye London, hello Shanghai" may not be a pipe dream. But if the Black Swan occurs in North Korea, then whatever I think is irrelevant.

I for one won't be going to Shanghai, but I am not a Master of the Universe. I don't care if Sterling is recovering. It is still cheaper to holiday in Barnstaple than Barcelona and there is one forecast I am optimistic about. As The Sun would say, "Phew. What a Scorcher!"

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