"A New Year Resolution"

If the past two years have been about transition the next two years are more than likely about resolution or the beginnings of resolution of some of the long-range tensions in the financial markets. You can go through a lot of fancy arguments, produce lots of graphs that mix up cause and effect, cite historic precedents rooted in a past when most people in the City of London were still at school, but to me there is no better way to illustrate our problems than to look at the relative wealth of nations through their reserves of money and gold. Lots of ideas and things to watch in 2007 flow from it and, although we don't have time to go into all of them right now (in this limited space), we should highlight some of them.

First of all - a sense of perspective (see first illustration). This shows the foreign exchange and gold reserves of the U.S. which looks impressive enough at around U.S.$50bn. Now let's add in another country for comparison (second illustration) and things now look somewhat less good. Even more surprising the country we added is . . . South Africa. Now you could argue that since South Africa is a gold producing nation that's not really fair. So lets add another country, say, the UK (see third illustration). Even that doesn't help the situation - the developed nations are clearly in a bad state relative to the developing nations like South Africa. But notice also the UK has about the same amount of reserves as the U.S. which is an economy about twelve times bigger than it. In other words, the real loser here is the U.S.

Now I'm going to scare you. Let's put China and Japan into the mix (see fourth illustration). At over a trillion US dollars alone, China is by far the biggest holder of reserves in the world and with a combined value of some U.S.$1.9 trillion Japan and China together dwarf the rest of the world in terms of fire power.

This is important. If it comes to it the U.S. dollar is in no position to defend itself. All the U.S. has is interest rate policy since, under the current administration, fiscal measures are out of the question. As we have found out here in the UK to our cost, interest rates don't control exchange rates especially when there is a panic on. The U.S. dollar is defenceless in this sense.

The second thing is that all of this money has to go somewhere and owners of these reserves have gradually stepped down the quality ladder from government bonds, to corporate bonds, to emerging market debt, equities, venture capital and so on. The result has to been to drive finanical assets prices up purely on the weight of money and confounding all the earnest traditional analysis that focused on domestic economics to rationalise investment valuations. You could say that the process of recycling earned wealth has been driving markets and validates the observation that our relationship with inflation has changed; net-net, money creation has inflated financial assets not high street goods which is different from the past. However, this is not all good; this foreign money searching for a home somehow ends up in the pockets of consumers in the form of debt.

In some respects this has been recognised by the U.S. Federal Reserve, the Bank of England and the European Central Bank who, by raising interest rates, have masked a plot to take excess money out of the system, as domestic economic policy. But this has been by and large a futile exercise because to be trully effective you need the cooperation of China and Japan which has hardly been forthcoming. The Japanese are in the throes of trying to create an orderly repatriation of money back to their domestic economy but, as we witnessed last February, keeping the emphasis on "orderly" is hard when trying to control hyper-active investors in the nursery that is the global financial markets arena.

There is a case for rates to be reduced going forwards in the west but as long the current process goes on central banks (like the UK last week) have no option but to try and deter this inward foreign investment by whatever means possible. Right now, this means interest rate increases and for that reason alone we are sitting on the sidelines with a low duration policy for the time being (duration being a measure of how price sensitive a bond or portfolio is to changes in interest rates).