Category: Money Moves Markets

G7 three-month LIBOR – a weighted average of individual currency rates – has fully reversed its September / October spike and is now below levels prevailing before Lehman failed. 10-year interbank rates are also at a new low – see chart.

Less encouragingly, the fall in LIBOR has been entirely due to actual and expected cuts in official rates, reflected in a large decline in overnight indexed swap (OIS) rates. LIBOR / OIS spreads remain significantly higher than in early September.

The lower absolute level of rates will support the economy, partly by boosting the disposable income of borrowers whose loans are tied to LIBOR or policy rates. However, banks’ continuing difficulties in raising wholesale funds, reflected in high LIBOR / OIS spreads, will constrain the supply of new credit.

As argued previously, policy-makers need to shift emphasis from official rate cuts to direct measures to boost money and credit, such as underfunding budget deficits, buying private sector assets and guaranteeing lending to firms and households.

Incentivising Northern Rock managers to run down its mortgage book at maximum speed never made sense in a wider financial and economic context – as argued here.

According to the Sunday Times, the government is now seeking Brussels clearance to delay further repayment of the Treasury loan, implying Rock will offer more attractive refinancing terms to its borrowers in order to keep their business. The new approach would presumably extend to the Bradford and Bingley mortgage book.

The article also suggests that the final Crosby report next week will propose a government guarantee scheme for mortgage-backed securities. This could further loosen mortgage supply – but only if the fees are set at a significantly lower level than for the existing credit guarantee scheme.

Let’s see if these reports are confirmed.

Banks need to boost their profitability in order to generate additional capital to support higher lending. Yet a measure of the gap between their average lending and deposit rates is close to its lowest level for at least 10 years.

Recent government-sponsored capital injections were calibrated to provide banks with a buffer against coming loan losses rather than support an expansion of lending. With market capital available, if at all, only on penal terms, banks are reliant on retained earnings to build the additional cushion necessary to support lending growth.

Net interest income is the largest element of banks’ earnings. The chart below shows estimates of average interest rates on banks’ and building societies’ sterling lending to the private sector and their M4 deposit liabilities. The estimates are derived from Bank of England data on effective interest rates on different types of loan and the composition of balance sheets.

The gap between the average lending and deposit rates – the net interest margin – recently reached its lowest level in the history of the data since 1999.

This may understate current pressure on banks’ profitability for three reasons. First, a compression of the margin from 2003 was offset by rapid balance sheet expansion, which is now ending.

Secondly, sterling lending exceeds M4 deposits by £476 billion, with the resulting “funding gap” bridged mainly by wholesale market borrowing. The cost of such borrowing has risen significantly since the credit crisis erupted.

Thirdly, fee income has fallen in reflection of weakness in financial markets.

Cuts in Bank rate may not boost the net interest margin much, if at all. Suppose the average loan rate is linked to Bank rate while the deposit rate varies with interbank rates – this is a simplifying assumption but may contain an element of truth, given government pressure to “pass on” Bank rate cuts and competition for savings. Bank rate cuts that were not fully reflected in interbank rates would then reduce the margin.

The three-month overnight indexed swap (OIS) rate – which measures market expectations of Bank rate – is currently 280 bp below its average in September (the last date in the chart), while three-month LIBOR is only 170 bp lower (based on yesterday’s fixing). Actual and prospective cuts in Bank rate have therefore yet to be fully reflected in interbank rates.

The government is further contributing to earnings woes via the charges levied for its various support measures. The fees on the special liquidity and credit guarantee schemes are significantly higher than for their US equivalents, as is the coupon on government-purchased preference shares. Banks are also partially liable for the cost of recent payouts to depositors under the Financial Services Compensation Scheme.

The November Inflation Report published today is very dovish and will boost expectations of a fall in Bank rate to below 2% by early 2009. In his press conference comments, Mr. King also appeared to welcome substantial fiscal loosening while playing down concerns about the plunge in the exchange rate. However, the commitment to maximum policy stimulus sits oddly with the Report’s forecast of a relatively shallow and short recession. Markets may begin to worry about a loss of financial discipline.

Key points:

• The mean CPI inflation forecast in two years’ time based on an unchanged 3% Bank rate is just 0.9%, by far the largest deviation from target in the MPC’s history – see chart. This compares with an above-target forecast of 2.2% in August.

• The associated fan chart implies a 20% plus chance of CPI inflation being below zero in two years’ time.

• While it is difficult to infer precise figures from the chart, the growth forecast based on unchanged rates is consistent with GDP declining by about 0.5% per quarter between Q4 2008 and Q2 2009, stabilising in Q3 and then recovering by 0.5% per quarter over the following year. This would imply a peak-to-trough decline in GDP of about 2%, with annual average changes of -1.3% in 2009 and +1.7% in 2010.

• As discussed in a previous note, an average path derived from the last three recessions would entail a peak-to-trough fall in GDP of 2.3% with a recovery delayed until Q2 2010. This path would imply an annual fall of 1.7% in 2009 with growth of just 0.4% in 2010.

• Mr. King also stated that an updated growth projection would be less gloomy because of prospective fiscal loosening and recent sterling weakness.

• The large and sustained inflation undershoot is questionable against the background of a moderate recession and a substantial fall in the exchange rate. Either the MPC’s GDP forecasts are insufficiently downbeat or inflation is likely to revive sooner than the Report projects.

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COMMENT:
AUTHOR: Gaurav
EMAIL: panchalgaurav@gmail.com
IP: 90.192.151.16
URL:
DATE: 11/13/2008 01:44:26 PM

Hello Simon,
It seems all along the way the severity of the crisis has been underestimated, the BoE included. Proof of which was the 150bps ‘panic rate cut’. There is way too much volatility in the markets (and datawise). The fear is that after a fall in inflation, deflation could become a reality in 2009. History has shown that bad news goes out with a bang and this is surely the worst. I feel that it is not as simple as it looks. Even the US TARP plan is being questioned and it has been proven that Europe/UK are one step behind the US in this financial crisis. Deflation could be real bad news.
Best Regards,
Gaurav
Journalist
London, England

The October Royal Institution of Chartered Surveyors (RICS) housing market survey suggests a recovery in turnover from current rock-bottom levels together with a slowdown in the rate of decline of prices. Smaller price falls would be consistent with the equivalent stage of past housing downturns – see previous post.

The survey confirms a recent slump in activity and prices. However, the new buyer enquiries index tends to lead turnover and price momentum and rose for the sixth consecutive month in October, though remains in negative territory – see charts below.

The earlier fall in the index was exacerbated by uncertainty about changes in stamp duty. The recent revival probably also reflects lower prices and expectations of interest rate cuts (the survey was conducted before last week’s MPC move).

The slowdown in negative momentum should not be mistaken for the approach of the end of the downturn. While turnover may be bottoming, the next stage of the price decline is likely to be driven by rising supply as unemployment climbs. As the earlier post showed, experience in the mid 1970s and early 1990s suggests a sustainable recovery in prices will be delayed until 2011 or beyond.

Three-month sterling LIBOR fixed today at 4.42%, down from 5.56% before the Bank rate cut and 6.28% as recently as 10 October.

LIBOR can be decomposed into the expected level of Bank rate – measured by the overnight indexed swap (OIS) rate – and the credit risk / liquidity premium banks need to pay to attract term funding.

Of the 186 bp decline in three-month LIBOR since 10 October, 163 bp reflects lower expectations of Bank rate with just 23 bp due to a narrowing of the bank premium, measured by the LIBOR / OIS spread – see chart. The spread is 190 bp today, down from a recent peak of over 230 bp but well above the 75-85 bp level prevailing before Lehman’s failure in September.

With banks’ lending rates mostly linked to either LIBOR or Bank rate, recent falls will bring significant relief to existing borrowers.

However, the high LIBOR / OIS spread suggests banks still face major difficulty raising funds to finance new lending. To the extent that banks are financing loans linked to Bank rate with borrowing linked to LIBOR, it also frustrates their efforts to widen net interest margins – necessary to rebuild capital in order to support additional lending.

The large fall in LIBOR is welcome but the LIBOR / OIS spread also needs to decline significantly to justify hopes that financial and economic risks are diminishing.

A comparison of the current housing market downturn with the slumps in the mid 1970s and early 1990s suggests prices could fall by a further 15% from October levels, with a recovery delayed until 2011 at the earliest.

On a quarterly average basis, the Halifax and Nationwide house price measures both peaked in the third quarter of 2007. By October, the Halifax index had fallen 16% versus 14% for the Nationwide.

The first chart below compares the inflation-adjusted decline in the Nationwide index with falls in the last three housing downturns – 1973-77, 1979-82 and 1989-95. The comparison is made in real terms because high inflation bore the burden of reducing housing valuations in the 1970s and early 1980s. The Nationwide index is used because the Halifax measure began only in 1983. The inflation adjustment is based on the retail prices index.

The decline in real prices since the third quarter of 2007 has closely matched the initial stages of the 1989-95 downturn. This was the most severe of the three, with a peak-to-trough fall in real prices of 37% over 26 quarters.

For comparison, real prices fell by 32% over 15 quarters in 1973-77 and 17% over 10 quarters in 1979-82.

The second chart reverts to nominal prices and shows illustrative scenarios assuming 1) inflation-adjusted house prices follow the same path as in 1989-95 or 1973-77 and 2) retail prices rise at a 2% annualised rate.

Interestingly, both scenarios suggest a bottom in nominal prices in the first half of 2011, at 15% and 13% respectively below the most recent – October – level. However, a repeat of 1989-95 would imply a further three years of stagnation, with a sustained recovery beginning only in 2014.

Could prices fall by even more than in the early 1990s? Based on the rental yield – a better measure than the house price to earnings ratio – housing overvaluation was less extreme in 2007 than 1989. Also, the early 1990s slump was exacerbated by sterling’s membership of the ERM, which constrained cuts in official interest rates.

However, these factors could be outweighed by the current mortgage famine, caused by banks’ efforts to shrink their balance sheets, high funding costs and the rapid rundown of Northern Rock’s loan book. Cuts in official interest rates alone will have limited impact on mortgage credit supply.

Drastic action was warranted but there is a risk of exhausting interest rate ammunition too soon. The cut will have limited impact unless the financial system starts to function normally. The MPC is hoping to shock money and credit markets back to life but the Fed’s rate-slashing failed to avert a US credit crunch. UK policy-makers may need to consider additional steps to ensure the flow of credit to firms and households, such as TARP-style purchases of private sector debt and an expansion of the small firms loan guarantee scheme.

Headline money supply M4 numbers have been artificially boosted by a rerouting of interbank business through non-bank financial intermediaries, partly reflecting the operation of the special liquidity scheme. Unlike interbank lending, the deposits of these intermediaries are included in the M4 definition.

The Bank of England’s industrial analysis of bank deposits, published yesterday, permits a more accurate estimate of this effect. Specifically, an adjusted M4 measure was calculated excluding deposits held by five industrial categories within the financial sector – bank holding companies, mortgage and housing credit corporations, non-bank credit grantors, “other financial intermediaries” and “other activities auxiliary to financial intermediation”.

While headline M4 climbed 12.4% in the 12 months to September, the adjusted measure rose by just 2.9% – the lowest annual growth rate since 1999. In the latest three months adjusted M4 contracted at a 2.7% annualised rate.

While the headline M4 numbers are hugely inflated, the adjusted measure could in theory understate underlying broad money trends, to the extent that the non-bank intermediaries have created money-like liabilities. However, the bulk of their borrowing will have been from banks so any such effect should be small.

The collapse in money growth, when correctly measured, adds to arguments for a large cut in Bank rate tomorrow. Incorporating today’s services PMI results, my MPC-ometer now suggests a 55% chance of a full-point move and 45% of 75 basis points.

As previously reported, the liquidity ratio of private non-financial corporations – their M4 money holdings divided by bank borrowing – is at its lowest since 1991.

Bank of England data published today permit an analysis of liquidity ratios by industry. The low level of the aggregate ratio mainly reflects weakness in the real estate and construction industries.

“Normal” levels of the liquidity ratio vary by industry so it is more informative to monitor developments relative to a long-term average. The first two charts below show industry ratios relative to averages since 1998, when the Bank of England data began. In addition to construction and real estate, liquidity has deteriorated significantly in “legal, accountancy, consultancy and other business activities” – closely linked to property and financial markets.

By contrast, the liquidity ratio in manufacturing is above its post-1998 average and much higher than before the industrial recession in 2001.

The third chart shows the aggregate ratio for private non-financial corporations split between real estate and construction and other industries. The other industries ratio has declined sharply recently but has yet to fall beneath its level before the 2001 economic downturn.

The less dramatic liquidity deterioration outside real estate and construction may temper coming declines in business investment and employment. However, the industry skew is bad news for banks – real estate and construction loans account for 54% of their sterling lending to private non-financial corporations, having grown at an 18% annualised rate over the last five years.