Category: Money Moves Markets

The Rock loan may have grown by a further £2.7 billion over the last week as negotiations about its future meander towards a conclusion. The increase from £1.1 billion in the prior week is consistent with reports of accelerating retail deposit outflows from the troubled bank. The cumulative rise since 12th September is now £29.1 billion (all figures based on changes in "other assets" on the Bank of England’s weekly return). Recent trends suggest the bank’s retail funding base may have largely disappeared by the time a bid is completed.

Against my expectations, US Treasury yields have fallen sharply in recent weeks. There are two explanations for the decline: a flight to (perceived) quality as the money and credit market “crisis” has intensified and rising fears of a global “hard landing”, involving a US recession and a sharp slowdown (at least) elsewhere.

If the latter explanation were the dominant factor, one would expect similar dramatic falls in other countries, particularly open economies with high exposure to the US. Yet in one such case – Korea – yields have been soaring not plunging. Five-year Korean Treasury yields have reached their highest level since 2002. Some special factors are involved but the rise has been mainly due to a combination of stronger-than-expected economic news and competition from rising money market interest rates.

Swings in Korean yields have historically coincided with or led moves in US Treasury yields – see chart. The recent divergence suggests that Korean bond market participants do not sense a coming US recession, while the fall in US yields mainly reflects a flight to safety, which could reverse sharply if money and credit market stresses abate.

Market Vane’s measure of bullish sentiment on US Treasury bonds has risen to 81%, the highest since 2003. Similar readings historically have often preceded at least a temporary rebound in yields.

Our MPC-ometer model predicts UK interest rate decisions based on a small number of economic and financial indicators. The model correctly explains 113 of 125 interest rate outcomes since the inception of the current policy regime in 1997 – a 90% success rate.

Earlier this year I applied the same analysis to ECB rate decisions and found a similar degree of predictability. The ECB-ometer includes 10 variables summarising trends in activity, inflation and financial market conditions. Eight of these variables also appear in the MPC-ometer, providing strong evidence of a common policy approach.

The chart below shows changes in the ECB’s main policy rate – the minimum bid repo rate – together with the ECB-ometer’s forecasts. Official rate changes are signalled by forecasts of +0.125% or higher and -0.125% or lower. The model correctly predicted seven of the eight increases over the last two years, with no false signals.

The ECB was widely expected to raise rates again in September, based partly on President Trichet’s use of the phrase “strong vigilance” at the August press conference. The model signalled an increased risk of tightening but the forecast of +0.12% fell just short of the trigger level. In the event, rates were left unchanged in September and “strong vigilance” was replaced by a commitment to “monitor very closely all developments” in the subsequent press statement.

The ECB-ometer’s forecasts fell back in October and November and the December reading is likely to be marginally negative, based on available data (estimate included in chart). The decline reflects weaker economic activity and tighter financial conditions, which have offset unfavourable inflation developments.

The ECB has continued to signal a tightening bias by emphasising upside risks to price stability in its monthly statements and speeches by key officials. However, the ECB-ometer suggests a neutral policy stance is now warranted by incoming data – see also here and here. The ECB is likely to retain a reference to upside inflation risks in the statement issued after next week’s meeting but this could be counterbalanced by acknowledgement that growth prospects have deteriorated, partly because of the strength of the euro. Such an adjustment would indicate a more symmetric policy outlook and could be the first step towards a rate cut in early 2008.

The Bank of England’s “other assets” rose by £1.1 billion in the week to 21st November, down from £2.0 billion in the prior week. The cumulative increase since 12th September is now £26.4 billion, the bulk of which will represent lending to Northern Rock. With Building Societies Association figures earlier this week suggesting a massive outflow of retail funds from the troubled bank (see here), the Rock loan looks on course to reach £30 billion by year-end.

In a post last week I explained that the G7 economic downswing is now a year old and at the critical point that has divided “soft” and “hard” landings historically – see first chart below. I still think a “hard” landing can be avoided, although recent further credit market turmoil and rises in energy costs have obviously increased downside risks.

The chart also shows the developed-markets “revisions ratio” – the net proportion of equity analysts’ company earnings forecasts that are upgraded each month. The revisions ratio is a good coincident indicator of the G7 industrial cycle and is published on a timely basis, with November figures released this week. Unsurprisingly, the ratio is now in negative territory – more forecasts are being downgraded than upgraded – but its level is currently still consistent with a “soft” landing. Further weakness is likely but the ratio needs to fall to -0.10 (i.e. a net 10% of all forecasts cut) to ring “hard” landing alarm bells.

I have argued that the consensus is too fixated with US recession talk and is underplaying downside risks in Europe. This theme receives support from regional revisions ratios, showing notable weakness in continental Europe (and Japan) in the latest month – see following chart. The ECB has been slow to acknowledge a deteriorating outlook but I think policy-makers will soften their stance at the December meeting and signal a possible rate cut in early 2008. This could take some of the steam out of the euro.

Minutes of the November MPC meeting reveal a 7-2 vote for unchanged rates, in line with our MPC-ometer forecast. A minor surprise was that Gieve joined Blanchflower in seeking a cut, while Bean and Lomax – who opposed the last rise in July – voted for stable rates.

The MPC-ometer forecast for December will be available at the end of next week but I think a 25 b.p. cut is likely. Failure to deliver would sit uneasily with the remarkably dovish November Inflation Report, indicating a 50 b.p. decline is necessary to prevent an inflation undershoot. More straightforwardly, three-month LIBOR has risen by 25 b.p. since the last MPC meeting so an official cut is arguably required just to offset market-led tightening.

The retail run on Northern Rock continued apace in October despite government guarantees on deposits, judging from Building Societies Association savings figures released today. Societies attracted a record £3.0 billion of new receipts, up from £2.8 billion in September and just £770 million in October last year. According to BSA Director-General Adrian Coles, “it seems that the majority of these deposits are funds withdrawn from the Northern Rock bank”.

A conservative guesstimate is that building societies enjoyed additional Rock-related inflows of £2.5-3 billion in September and October combined. With societies accounting for 20% of the retail deposits market, this suggests total withdrawals from the troubled lender of £12.5-15 billion for the two months, equivalent to more than half of its £24.3 billion of retail funding at mid-year.

Money supply figures also released today showed monthly M4 growth of just 0.1%, down from 0.9% in September. Details reveal that the drop reflected a fall in “net sterling lending to non-residents”. This is likely to be related to selling of UK securities by foreigners in the wake of the Northern Rock crisis.

One of my “favourite external links” is to the weekly market comment written by US economist and fund manager John Hussman. Hussman has been downbeat on the US economy for some time but has argued there was insufficient evidence to forecast a recession. He now thinks the balance has tipped, as explained in last week’s comment, titled “Expecting a recession”.

Other forecasters and media pundits have also been piling on the gloom recently. The Economist  this week opined that "recession in America looks increasingly likely".

Hussman’s approach is admirably empirical. He describes a “rule of thumb” based on four conditions that have been jointly observed in every US recession. The conditions are:

1. A widening of credit spreads from six months earlier.

2. A flat yield curve, defined as longer-term Treasury yields no more than 2.5% above three-month yields.

3. A fall in the stock market from six months earlier.

4. A purchasing managers’ index for manufacturing of 54 or lower coupled with either non-farm employment growth of less than 1.3% over the prior 12 months or a rise of 0.4 percentage points or more in the unemployment rate from its 12-month low.

Conditions 1, 2 and 4 were met in October and condition 3 is likely to fall into place in November – the S&P 500 has averaged 1478 month-to-date compared with 1511 in May. Hussman therefore now believes a recession is immediately ahead.

The economy was much stronger than the bears forecast in the second and third quarters. I have been expecting a sharp slowdown in growth in the fourth quarter but no recession, at least yet. Should I change my view in light of Hussman’s analysis?

I have to concede that his rule of thumb works well historically. There have been eight US recessions since 1950, according to the National Bureau of Economic Research. Hussman’s indicator gives a signal either before or during all eight. Even more impressively, there are no false signals.

However, it bothers me that the indicator ignores information on the magnitude of the underlying variables. One might reasonably expect the values of the change in credit spreads, yield curve slope, change in stock prices etc. to be relevant to the assessment of the probability of a recession.

To investigate this, I estimated a statistical model for assessing whether the economy is currently in a recession using the values of the Hussman variables. I included current and six-month-ago values to allow for lags in the relationship. The fitted probability estimates of the model are shown in the chart below. Historical performance is similar to the rule of thumb, with all eight recessions since 1950 signalled by the probability rising above 50% and no false signals. However, unlike the simple rule, the model has yet to flash red in the current cycle, with a latest reading of 20%.

I described my own recession probability indicators in an earlier post. The version including credit spreads has been rising recently but has also yet to breach 50% (current reading 45%).

Downside economic risks have clearly increased with further weakness in credit markets and rises in energy costs but I still think a recession can be avoided.

“Other assets” on the Bank of England’s balance sheet rose by £2.0 billion in the week to 14th November following a £500 million gain in the prior week. The cumulative rise since Northern Rock imploded is now £25.3 billion.

Is the Bank providing covert support to banks other than Northern Rock? It is possible but unlikely. In an interview conducted on 1st November Northern Rock chairman Bryan Sanderson stated that the loan was “not quite £20 billion”. This figure compares with estimates from the Bank return of £20.6 billion on 24th October and £22.8 billion on 31st October. Mr. Sanderson may have been referring to the size of the loan a few days earlier, i.e. nearer 24th October than 31st. The discrepancy could also be explained by a rise in other components of the Bank’s “other assets” since it started to lend to Northern Rock. In testimony to the Treasury Committee, Bank of England Governor Mervyn King stated that the Bank was unable to lend covertly to Northern Rock because of the Market Abuses Directive, although this interpretation has been denied by the European Commission. Term interbank rates have been stable in recent weeks and might have been expected to rise if other banks were facing significant funding difficulties.

The November Inflation Report is remarkably dovish and signals the MPC expects to cut Bank rate by 50 b.p. over coming months.

Key points:

1. The two-year-ahead inflation forecast assuming unchanged 5.75% rates is far below target at an estimated 1.75% (both mode and mean). This is the largest negative deviation in the MPC’s history – see chart.

2. The forecast based on market expectations of a 50 b.p. rate cut by the third quarter of next year is exactly on target.

3. The modal GDP forecast based on unchanged rates shows annual growth slowing sharply from 3.3% currently (expected by the Bank to be revised up to 3.5%) to below 2% by the third quarter of 2008.

4. Risks to the forecast are judged to be balanced for inflation and on the downside for growth, versus on the upside and balanced respectively in the August Report.

So why were rates not cut last week? The minutes will reveal more but the MPC probably wanted to set out its revised economic thinking before acting to avoid accusations of bailing out the financial sector. The forecast that inflation will remain slightly above target during 2008 may also have influenced the majority decision to delay.

Time will tell whether recent financial events warrant the MPC’s dramatic forecast revisions; the economy could well prove more resilient than assumed. However, the Committee’s bias is clear and it is reasonable to expect two quarter-point rate cuts by next spring. I will be guided by the MPC-ometer but the first cut could come as early as next month, with a follow-up move possible in February.