Could central banks cause a crash?

That’s the question RBS is asking. In recent research, Bob Janjuah, the bank’s credit strategist, advises clients to move to safety in anticipation of potential market volatility. The crux of the matter is inflation and central bank credibility.

Janjuah’s argument goes a bit like this:

• Markets are extremely nervous as we have just experienced a credit crisis of monumental proportions and many economies are slowing to a crawl as a result.
• To make matters worse, inflation is creeping up
• To confront this twin nightmare, central banks, notably the U.S. Federal Reserve, the Bank of England (BoE) and the European Central Bank (ECB) must act by choosing inflation over growth and raise rates despite the credit crisis.
• If they do not, they will lose credibility
• As a result, we would see a massive crash of risky assets

Consider this the armageddon scenario. In his own words, Janjuah says:

“I do not think I can be much blunter. If you have to be in credit, focus on quality, short durations, non-cyclical defensive names.

“Cash is the key safe haven. This is about not losing your money, and not losing your job,”

But, Janjuah must be taken seriously. Last year, he became a star in the City of London when his dire warnings about the credit crisis proved bang on.

Lena Komileva, Chief Economist at Tullet Prebon, adds fuel to this fire. Monday, in an interview with Tom Keene at Bloomberg News’ show “Bloomberg on the Economy” she said that financial risk is even higher than it was when Bear Stearns collapsed in March.*

Are we at risk of a crash? Sell in May and go away?

Sources
RBS issues global stock and credit crash alert, The Telegraph, 18 Jun 2008
Draghi Sees `Fragile Stability’ in Financial Markets, Bloomberg News, 14 Jun 2008
Greenspan Says Markets Show `Pronounced Turnaround,’ Bloomberg News 13 Jun 2008
Libor/OIS spreads narrow but tensions remain, The Guardian, 13 Jun 2008

*Komileva cited one-year LIBOR-OIS spreads, as the measure of risk in the market. It measures the differential between the rate at which banks lend to one another in comparison to the lending rate required to swap a floating for a fixed rate of interest. A high LIBOR-OIS spread suggests that credit markets are very fragile. Alan Greenspan apparently agrees, specifically citing the LIBOR-OIS spread needing to come in 25bps (down to 50bps) in order to return to pre-credit crisis August 2007 levels of financial risk.