Author: admin

First-quarter flow of funds accounts released yesterday by the Federal Reserve show a further decline in non-financial companies’ borrowing requirement, defined here as their “financing gap” – capital spending minus domestic retained earnings – plus share purchases net of issuance. The borrowing requirement is a leading indicator of credit spreads – see chart and previous post.

The borrowing requirement amounted to 1.5% of GDP in the first quarter, down from a high of 9.5% in the fourth quarter of 2007. In the late 1980s and early 2000s, borrowing peaked eight quarters before the high-yield spread over Treasuries. Credit has rallied much earlier in this cycle, possibly because spreads reached more extreme levels in late 2008 than in the prior two bear markets. The historical two-year lead suggests that further significant spread compression could be delayed until 2010.

At 1.5% of GDP, the first-quarter borrowing requirement was below its average of 2.3% since 1985. The further fall last quarter mainly reflected a large cut in capital spending as companies slashed fixed investment and ran down stocks. A decline in net share buying also contributed, while firms offset profits weakness by reducing dividends, resulting in stable retained earnings.

Looking forward, an end to destocking should contribute to a significant rebound in capital spending over the remainder of 2009. The impact on the borrowing requirement, however, may be offset by a recovery in profits as economic growth resumes and a further fall in net share purchases, with companies using the opportunity provided by better markets to step up issuance.

Critics of the banks accuse them of boosting margins by failing to pass on Bank rate cuts to borrowers. The banks’ last trading statements, however, complain of downward pressure on net interest income. Who is right?

The chart below shows estimates of average interest rates charged on M4 lending and paid on M4 deposits, derived from disaggregated Bank of England data. (The M4 data cover banks’ and building societies’ sterling business with UK households and corporations.) The difference between the average lending and deposit rates is a measure of banks’ net interest margin.

The critics are factually correct to complain of a measly decline in lending rates. Between November 2007 and April 2009 Bank rate was cut by 525 basis points but the average interest rate on M4 lending fell by only 310 basis points. This implies much lower pass-through than during the last big easing of monetary policy, in 2001-03, when Bank rate fell by 250 basis points and the M4 lending rate by 220 basis points.

The benefit to banks of a higher margin on lending, however, has been entirely offset by the disappearance of their deposit margin. In November 2007, the average interest rate on M4 deposits stood at 4.6%, 115 basis points below Bank rate of 5.75%. By April 2009, it was 110 basis points higher – 1.6% versus 0.5%.

In other words, the M4 deposit rate fell by only 300 basis points between November 2007 and April 2009 – slightly less than the average lending rate. Far from bolstering their profits at the expense of hard-pressed borrowers, banks have actually suffered a further decline in their net interest margin over this period – see chart.

Why has the average deposit rate proved so sticky? Clearly the maximum possible fall would have been 460 basis points – its level in November 2007. In practice, banks have been forced to continue to offer interest on sight (i.e. instant access) deposits in order to retain funds – not least because of competition from state-run savings. Meanwhile, the unforeseen collapse in Bank rate has left them temporarily saddled with high term funding costs: the average interest rate on household bank time deposits was still 4.6% in April 2009.

As term funding matures and is refinanced at lower rates, banks should be able to reduce the M4 deposit rate towards Bank rate. Coupled with higher margins on new lending, this should allow a significant recovery in the lending / deposit rate spread. As the chart shows, the spread is currently at an historical low – even a 100 basis point rise would simply return it to the average over 1999-2005, before the recent credit bubble.

Banks are already being accused of profiteering despite a further squeeze in their net interest margin; imagine the furore if they succeed in boosting their profitability. Such a development, however, is needed to speed capital rebuilding and support future lending growth. Moreover, restoration of the margin to a normal level is the mirror-image of an appropriate repricing of credit risk – spread compression in 2006-07 contributed to the lending bubble.

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COMMENT:
AUTHOR: Peter
EMAIL:
IP: 86.156.240.52
URL:
DATE: 06/11/2009 10:39:11 AM

HSBC have increased the interest charges on private overdrafts to between 16% and 18% depending on whether the customer has an account that charges a monthly fee, or has investments with the bank of £50,000 or more.

This compares with interest rates of 12% a year or two ago, and 2 to 4 % over base in the slightly more distant past.

Sympathy for the banks is misplaced. I believe the rates currently charged to be usurious

Perhaps the banks are a good investment bet, because at this rate they should be in substantially increased profit very soon

The Bank of England’s Bankstats publication this month contains for the first time a table providing detailed figures for “adjusted” M4 and M4 lending – i.e. excluding banks’ business with financial intermediaries (“intermediate other financial corporations”). If these series had been made available 12-18 months ago, economists and the MPC would have been better able to anticipate the recession.

The Bank was aware of possible problems with its M4 and M4 lending measures in 2007: an article in the September Quarterly Bulletin proposed a redefinition to exclude intermediaries while the November Inflation Report warned that growth rates were being inflated by the financial crisis. Since May 2008, the Inflation Report has contained a chart showing the annual growth rate of adjusted M4; this was extended to M4 lending in August last year. The fuller data set published in the new Bankstats table could, in theory, have been made available at least a year ago.

The chart shows a measure of economic momentum based on the purchasing managers’ surveys – a weighted average of the services new business and manufacturing new orders indices – together with the six-month growth rate (not annualised) of real adjusted M4 (i.e. deflated by consumer prices). In contrast to the headline measure, real adjusted M4 slowed abruptly in late 2007 following Northern Rock’s implosion and contracted during the first half of 2008 as inflation spiked higher. This weakness warned of serious economic deterioration at least three months before the purchasing managers’ indicator fell below the key 50 level in May 2008.

The MPC reduced Bank rate in December 2007, February 2008 and again in April then held it at 5.0% until October. It is debatable whether members pay much attention to monetary trends but, had the adjusted data been available, there is at least a chance that the Committee would have cut further over the summer despite a surge in headline CPI inflation to a September peak of 5.2%. It might also have been swifter to heed external recommendations for quantitative easing.

Just as it led on the way down, the adjusted money measure also foreshadowed the recent improvement in economic news. The six-month rate of change troughed last September and has recovered steadily, currently running at about 3% – a level historically consistent with economic expansion. The purchasing managers’ indicator bottomed in November last year and the recent move back above 50 appears to confirm that the economy has stopped contracting.

Is the US labour market improving, or at least deteriorating less rapidly? Employees on non-farm payrolls dropped by 345,000 in May – lower than expected and down from an average of 612,000 over the prior three months. An alternative payrolls measure derived from the household survey, however, fell by 833,000, contributing to a further rise in the unemployment rate to 9.4%, a 26-year high.

The jury is out but two other indicators support the more hopeful message from the “official” payrolls series. First, a smoothed measure of employment taxes withheld at source (equivalent to UK PAYE) has edged higher since February – see first chart. Unsurprisingly, withheld taxes are a good coincident indicator of labour incomes and successfully delineated the last recession. (The numbers have been adjusted to take account of a cut in the withheld tax rate from April.)

Secondly, the outplacement firm Challenger, Gray & Christmas Inc’s monthly tally of job-cut announcements has fallen steadily from a peak of 234,000 (seasonally adjusted) in January, reaching 111,000 in May – the lowest since September. The series correlates with weekly initial unemployment claims and suggests that claims will extend their recent small decline – second chart. This, in turn, would be consistent with an imminent peak in the unemployment rate.

An earlier post made a case for comparing the recent decline in US share prices with the bear markets of 1906-07, 1919-21 and 1973-74. Like the 2007-09 bear, the falls in 1919-21 and 1973-74 occurred at or near the end of 30-year economic cycles. Meanwhile, the 1906-07 decline was associated with a financial panic with similar characteristics to the Lehman crisis.

The three earlier declines bear a close resemblance, with the Dow Industrials index falling by 45-49% over 22-23 months. The subsequent recoveries also look similar – three years after the start of its decline, the Dow had rallied to stand 17%, 17% and 13% respectively below its peak level.

The earlier post included a chart overlaying the 2007-09 decline on the three earlier bear markets and recoveries. This approach has been taken further in the chart below, which shows a “three-bear average” of the prior episodes. This average provides a template for comparison with current developments; it may also offer guidance on share price prospects.

The Dow peaked in October 2007 and followed the three-bear average closely until September last year, when the Lehman crisis led to a dramatic lurch down. The deviation widened in early 2009 as fears of banking system nationalisation exacerbated weakness. The rally since March, however, has closed the gap and the current level of the Dow is now only marginally below the template.

The average declines further over the summer, reaching a low about 10% below yesterday’s Dow close at the start of September. It then embarks on a sustained rise, climbing 25% from the September low by the end of 2009 and a further 27% during 2010.

Historical comparisons should be treated with caution but the shape of this “forecast” appears plausible. The recent rally has been driven by a reallocation of cash to equities by investors who had been underweight; a period of consolidation may be necessary before a further advance based on a recovery in corporate earnings – conditional, of course, on the global economy returning to growth later in 2009.

The MPC-ometer is designed to predict the outcome of each month’s MPC meeting based on incoming economic news and financial market developments. It forecasts no change in either Bank rate or quantitative easing plans at today’s meeting.

The balance of news over the last month is judged to be neutral. Growth and financial market indicators have improved: business surveys are stronger, the stock market has rallied further and interbank interest rates have fallen. Inflation indicators, however, have weakened, with the headline CPI increase slowing sharply and first-quarter average earnings down by 0.1% from a year earlier.

The MPC last month expanded its quantitative easing programme to £125 billion, implying that Bank of England asset purchases will continue until the end of July. QE is intended to boost money supply growth. The latest monetary statistics suggest that the policy is working. A decision about a further extension will probably be deferred until next month’s meeting.

The MPC’s favoured money supply measure – broad money M4 excluding cash holdings of financial intermediaries – is estimated to have risen by a chunky 1.0% in April. Growth has been running at a 7.8% annualised rate so far in 2009, up from just 3.0% during the second half of last year.

QE works by boosting investors’ cash holdings, thereby encouraging them to buy private-sector securities. This raises asset prices and makes it easier for companies to float new equity and bond issues. Corporations raised £13.6 billion from sterling capital issues in the three months to April, up from just £3.8 billion in the previous three months.

Stronger monetary growth supports hopes that the economy will stabilise soon. The recent pick-up, however, needs to be sustained to lay the foundations for an economic recovery in late 2009 and 2010.

Most commentators appear to have missed the big story in yesterday’s monetary data – the 1.0% rise in the Bank of England’s adjusted M4 proxy in April (see previous post). Reports focused instead on the 0.1% monthly contraction in bank lending to households and non-financial corporations. According to the consensus, the lending decline is evidence of a continuing credit crunch and signals further economic weakness.

Three points are worth emphasising. First, empirical analysis shows that money leads the economy whereas credit lags. This is why the US Conference Board includes the real M2 money supply in its index of leading indicators, while real commercial and industrial loans and the ratio of consumer credit to personal disposable income are components of its lagging index.

Secondly, credit trends are nonetheless important to the extent that they influence monetary growth. The MPC, however, has correctly chosen to offset the monetary impact of credit weakness by buying gilts. This policy should and presumably will continue until credit growth revives and resumes its normal role as key driver of monetary expansion.

Thirdly, it is impossible to disentangle supply and demand effects on credit trends. Recent weakness may have been demand-led, reflecting a reduced need for working capital as stocks are run down together with companies taking advantage of more favourable market conditions to float new issues, using the proceeds to repay bank debt.

The adjusted M4 proxy is volatile and it would be unwise to read too much into a single month’s increase. The MPC, however, should be reassured by the faster pace of growth so far this year, suggesting that a decision about expanding the QE programme further will be deferred until next month’s meeting.

Two Group of Seven (G7) countries have released April industrial output figures: the US registered a 0.5% decline and Japan a 5.2% gain – see first chart. The Japanese rise dominates and suggests a small increase in G7-wide output in April barring significant weakness in European data due in a fortnight’s time.

G7 output peaked in February 2008. A bottom in March 2009 would imply a 13-month recession, similar to the duration of the 1974-75 and 2000-01 downturns (12 and 11 months respectively) – second chart. The recent fall, of course, has been much larger, with a 19% peak-to-trough drop versus 12% in 1974-75 and 7% in 2000-01.

A post last December predicted a G7 output bottom in March based on a pick-up in inflation-adjusted narrow money M1. Real M1 is showing very strong annual growth, supporting near-term economic recovery hopes – third chart. It has, however, slowed over the last three months – further weakness could signal a loss of economic momentum in late 2009.

With a 0.1% fall in consumer prices in the year to May, Germany becomes the fourth Group of Seven (G7) country to record headline “deflation”, following the US, Japan and the UK (the latter based charitably on the retail prices index, which incorporates declines in mortgage rates and house prices, as well as the December VAT cut).

G7-wide consumer prices were down an annual 0.3% in April. The fall reflects a collapse in commodity prices from their levels a year ago – see chart. The rate of change of “core” CPI – excluding food and energy – remains positive in every country bar Japan, averaging an annual 1.5%. As the chart shows, the commodity price effect will reverse in late 2009, assuming no renewed decline from current levels.

Headline inflation should therefore converge on core. Core inflation should decline in 2009-10 as global excess capacity undermines pricing power. After the last recession it fell to an annual 1.0%. Headline G7 inflation could rebound to around this level in early 2010 – higher if commodity prices continue to rally.

Deflation, like inflation, is a monetary phenomenon. The global money supply continues to grow healthily, arguing against a sustained period of falling prices.

Today’s Financial Times draws attention to the huge deterioration in the UK’s relative inflation performance caused by last year’s plunge in the exchange rate, a topic discussed in an earlier post. Its observations, however, should be qualified in two respects.

First, the FT uses the CPI excluding indirect taxes as a gauge of “true” inflation, i.e. adjusting for the impact of December’s VAT cut. This rose an annual 3.8% in April versus a 2.3% increase in the headline CPI. A better measure, however, is the CPI at constant tax rates (CPI-CT), which climbed by a smaller 3.4%.

Moreover, both of these alternative indices are based on the assumption that the VAT reduction was passed on in full – highly unlikely. Using a more realistic estimate of 50% pass-through, “true” inflation in April was 2.8-2.9% (i.e. halfway between the headline 2.3% and 3.4% CPI-CT increases).

Secondly, as discussed in a post last week, recent sterling strength – if sustained – promises a reduction in imported inflationary pressures later in 2009. The MPC’s central-case forecast that the annual CPI increase will slow to 0.4% by the fourth quarter looks much too optimistic but the gap between UK and US / Eurozone inflation is peaking and should narrow significantly.

For the gilt market, supply is likely to represent a greater threat than relatively high UK inflation. The stock of gilts in market hands should shrink by about £50 billion over March-July, with Bank of England purchases of £120 billion offsetting net issuance of £70 billion. If the MPC were to suspend QE purchases from August, however, the market would need to absorb supply of £130-135 billion in the final eight months of 2009-10. (The DMO plans to issue a net £203 billion this fiscal year, based on the Treasury’s forecast of public net borrowing of £175 billion.)

In other news today, minutes of this month’s MPC meeting show that that some members favoured expanding QE by £75 billion rather than £50 billion, while the Committee discussed writing a letter to the Chancellor requesting an increase in the £150 billion limit “should economic conditions require it”. This is likely to fuel expectations that gilt-buying will be extended beyond early August but such a decision will depend importantly on forthcoming monetary data (provisional April broad money numbers are released tomorrow).

Meanwhile, Inflation Report forecast tables show that the MPC expects annual average GDP changes of -4.0% in 2009, 1.1% in 2010 and 2.7% in 2011 in its central case based on market interest rate assumptions. However, its mean projections – taking into account a negative risk skew – are much weaker, at -4.2%, -0.2% and 1.6% respectively. This looks excessively gloomy – see last post.

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COMMENT:
AUTHOR: Jonathan Purle
EMAIL: jp@intethic.com
IP: 81.130.114.169
URL: http://www.intethic.com
DATE: 05/21/2009 08:55:39 AM

Good morning Simon.Some of us feared that QE would lead to a bond bubble. Something similar occurred in Japan, even though BoJ focussed on purchasing securities directly from Banks and there was little seemingly direct impact on broad money (M2+CDs). Obviously the UK approach of buying gilts and bonds from the non-Bank sectors would imply that this could be more pronounced. The arithmetic suggests the gilt market is being held up by QE purchases and will crash when this eventually ceases (unless the ‘independent BoE’ actually carries on monetising these huge deficits for ever and a day).

– Do we have a gilt bubble? Or to what extent do you think the market is discounting the end of QE?

– To what extent do you believe QE is holding up the market in investment-grade bonds? There is little direct purchasing by BoE going on – a fraction of what was originally proposed…

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COMMENT:
AUTHOR: Simon Ward
DATE: 05/22/2009 05:25:53 PM

Thank you for your comments. On your second question, QE has probably had more impact on corporate bonds than the low level of Bank purchases would suggest, as cash injected via gilt-buying finds other homes. However, the rally appears mainly to have reflected global factors. It would be surprising if spreads widened significantly when QE ends.

It seems difficult to argue that QE has caused a gilt bubble – yields have reversed their initial decline remarkably quickly. To the extent that there was / is a bubble, it reflects excessive gloom on economic prospects and complacency on inflation, rather than QE. However, I share your concern that the market is not fully prepared for the scale of the coming swing from net official purchases to sales.