Waiting in Starbucks, there are signs of weakness in the economy. I am sat minutes from the centre of ground-zero - Canary Wharf - and the coffeehouse is virtually empty on the weekend morning. I am greeted by a sever with a chirpy English accent, a surprise given how accustomed I had become to staff from Eastern Europe. There are signs that many of the recent immigrants to the UK from countries like Poland are starting to leave the country as the economy starts to worsen.

The trader I am interviewing arrives. Matt Wilkings is a GBP swaps trader at JPMorgan. He has seen the credit crisis unravel from the cockpit of the world’s economy – an American investment bank.

Wilkings doesn’t begin where most surveys of the current economic scenario start. 

Parts of the world –  primarily the fast developing economies in Asia – have been saving excessively. Those savings were lent as credit to borrowers in the West. In the absence of high-grade borrowers it is impossible to stop credit being lent to lower quality risks. This is the situation that the Bank of England (BoE) found itself in. The tool to issue the high risk lending has been credit derivatives. Clamping down on the use of such products wouldn’t have had an effect on what was going on, however. Had they been more highly regulated, another mechanism would have been found.

Given this situation, what could the BoE have done differently? 

The Monetary Policy Committee –  the BoE’s interest rate setting group – sets rates to stabilise prices in the UK. Wilkings explains that since the crisis began in 2007, 1 year forward interbank lending rates, i.e. red short sterling futures contracts, have been almost perfectly correlated with movements in the price of Oil. The same can be said of corn, wheat, and any number of commodities products being driven by speculators and the increases in assumed demand in the developing world, notably China. Commodity prices rose to record levels on the back of this speculation in the early half of 2008. They then fell away sharply over the last six months of the year.

It has been clear to the trading community that the MPC got so caught up in what was an asset bubble waiting to burst, that they neglected the wider problems. Banks weren’t lending, and hence interbank lending rates blew up. The rate increases hurt the housing market, enough that default rates started climbing. More than the actual defaults, the fear of increasing defaults caused investor appetite for credit to dry up.

Wilkings noticed the effects immediately:  LIBOR shot up. LIBOR is the average rate at which banks are willing to borrow and lend to one another across currencies.  The loans are fixed to mature over a period ranging from overnight to one year and are sold as contracts according to the length of their duration. He trades these rates on a daily basis, usually with a carry trade that accounts for different interest rates over currencies.

In particular, two rolling 3 month loan contracts began to trade at a substantial discount to a 6 month contract as a result of the higher level of risk or credit exposure or risk from the lack of a 3 month reset. A number of traders were hurt. The reason: banks were no longer willing to trust one another –  failing to agree on the creditworthiness of contracts ranging from overnight to 12 months. Essentially there is less credit exposure or risk for a bank to lend for 3 months and then lend again at the end of that 3 months for another 3 months, than lending for 6 months today. This badly affected investor demand for bank debt. 

Of particular note was the difference in interest rates charged by banks between lending for 3 months outright and the safer move of lending overnight on a rolling basis for 3 months, – known as the FRA/Sonia spreads in the UK. The difference in interest rates between these two categories of loans blew from an historic low of 3-5 basis points (0.03%-0.05%) to over 150 basis points (1.5%), exploding on two particular periods in August 07 and Lehman Brothers’ default in September 08 when it became clear there may be fears over liquidity – the amount of cash readily available to banks.

These signs, he argues, should have been a key trigger for the MPC to aggressively cut interest rates to encourage lending between banks. They didn’t. Instead they continued to track Oil and push rates up. Confidence and credit in banks dried up.  

As we sit in Starbucks the swaps trader paints the picture of a grim few years for the UK. The government alone can’t replace all the world’s creditors. As people see the government taking on more debt they cut back on spending, and save more, all leading to a weaker economy and higher unemployment. Either that, or several years of high inflation prompted by the quantitative easing (the printing of additional cash which can then be used to pump more liquidity into the economy) which the BoE the plans to carry out over the next few months.

Could things be worse elsewhere I asked? Ireland. Matt believes that Ireland could be the weak link in the euro zone.  “There is a real risk that Ireland may default on its national debt, if it does then the Euro will have real problems”. The Irish economy has suffered falling house prices and high unemployment along with costly nationalisation of Irish banks. The cost to hedge against losses on Irish debt rose to a record 355 basis points (3.55%) – meaning that for every £100 of debt, investors have to pay £3.55 to insure against default. This is a sure fire sign that investors are concerned about the country’s prospects. It was about 262 basis points at the end of January. 

The problem is that as an EU member, the Irish can’t change interest rates or foreign exchange to help fix their deficit as the UK can. Nor can they get the printers out and create cash. They can issue debt to pump the economy with cash, but with an inability to print cash, they will soon run out of money in order to keep rates down. As we speak the 5y Germany vs Ireland government debt spread is blowing up, and there doesn’t seem to be any signs of it abating. If things are bad for us, the future is at least as bleak for a number of European states. 

From that point of view, hard as it may be to imagine, things could be worse in the UK.

Ravi is a Third year DPhil Student in Statistical Finance. He is Graduate Officer for the Oxford Investment and Finance Society and has a weekly radio show discussing themes in financial markets and the investment community.