Blog

I have been tracking the path of annual industrial output growth in the Group of Seven (G7) major economies against “soft landing” and “hard landing” scenarios, based on average experience in prior downswings over the last 40 years. Despite the credit crisis, my bias has been to expect an outcome closer to the soft landing path, for reasons explained here.

The first chart below updates the comparison to include February industrial output data. Activity held up reasonably well in early 2008 and continues to track the historical soft landing path closely. Supportive factors have included solid export gains to emerging markets and modest stock levels in late 2007.

I still think a hard landing will be avoided but further credit tightening and commodity price gains in early 2008 may result in growth moving slightly below the soft landing path over coming months. As the second chart shows, business surveys are consistent with the annual output change falling close to zero.

UK net mortgage lending last year totalled £108 billion (see here). Of this, only £27 billion ended up on the books of banks and building societies. The other £81 billion was assumed by “other specialist lenders” – often bank subsidiaries largely funded in wholesale markets.

Reflecting the shut-down of wholesale funding, these specialist lenders reduced their mortgage book by nearly £5 billion in the first two months of 2008. Assume – optimistically – that their net lending is zero for the year as a whole. If mortgage demand remained at £108 billion, and banks and building societies planned again to lend only £27 billion, this would imply a “funding gap” of £81 billion.

The actual gap is likely to be significantly lower, for three reasons.

First, banks funded £10 billion of the £81 billion advanced by specialist lenders in 2007. This £10 billion will be available to finance their own lending in 2008, reducing the estimated funding gap to £71 billion.

Secondly, mortgage demand would have fallen as a result of Bank rate rises and a slowing economy even in the absence of the recent tightening of lending standards. In the last housing slowdown in 2004/5, when supply conditions remained generous, the 12-month running total of net mortgage lending declined 22% from peak to trough. A drop in mortgage demand on this scale in 2008 would cut the implied funding gap from £71 billion to £47 billion.

Thirdly, a portion of the funds that last year were invested in wholesale markets will this year end up in bank and building society deposits, creating extra lending capacity.

Of course, any contraction of specialist lenders’ mortgage books would offset these factors, boosting the funding gap.

I think the authorities need to offer about £40 billion of additional funding assistance to mortgage lenders this year. The previous post discussed detailed proposals.

The purchasing managers’ surveys are reasonable coincident indicators of economic activity. The charts below show quarterly GDP growth together with a weighted average of PMI new business indices covering the manufacturing and services sectors for the US, Eurozone, UK and Spain.

Somewhat surprisingly, the UK PMI indicator has held up best in early 2008, suggesting growth of about 2% annualised. The Eurozone indicator has also been relatively resilient, while US surveys look consistent with a flat economy, supporting other evidence that a fall in GDP may have been avoided in the first quarter.

The stand-out, however, is the collapse in the Spanish PMI indicator. The government plans significant fiscal stimulus but can the ECB continue to ignore a developing recession in the Eurozone’s key locomotive economy of recent years?

Three-month sterling LIBOR eased to 5.95% at its fixing yesterday but remains detached from Bank rate at 5.25%. As well as the appropriate level of official rates, the MPC ought to discuss ways of closing this gap at its meeting this week.

The Bank of England’s money market operations are no longer a technical adjunct of the policy process but have become central to achieving the MPC’s aims. Mervyn King has promised new facilities to ease banks’ longer-term funding difficulties. The form and scope of such measures should be discussed and decided upon by the full MPC, not a select group of Bank officials. To emphasise its increased focus on market rates, the MPC could communicate its plans for narrowing LIBOR / Bank rate spreads along with its rate decision at midday on Thursday.

My MPC-ometer suggested financial market pressures warranted a cut in Bank rate last month. It has stuck to its guns this month, forecasting a 6-3 vote for a quarter-point ease. Interestingly, the Sunday Times Shadow MPC also voted 6-3 for a reduction, with one member seeking a half-point move.

—–
COMMENT:
AUTHOR: David Jebb
EMAIL: david.jebb@f-f-p.co.uk
IP: 80.76.195.144
URL:
DATE: 04/08/2008 08:55:24 AM

Simon,

From my limited access to information it appears that central banks will "bail out" problem banks by disentanglement of good and bad assets.

Have you any feeling on the amount of money this will take as a percentage of what the central banks holding as reserves. I think this is important because if the central banks are going to have to effectively print money,even if the instuments they buy are not worth very much they are still worth something so perhaps this would reinforce the price trend appearing in food and I can then steer my clients towards a higher inflation environment.You may have allready dealt with this in previous work in which case please refer me but in any event your thougths would be appreciated

Thank you

David Jebb (Chartered Financial Planner)

—–
COMMENT:
AUTHOR: Simon Ward
DATE: 04/09/2008 08:06:32 AM

You are right that the authorities are encouraging banks to separate good and bad assets and there is likely to be some element of public subsidy for the latter. For example, the US Congress is discussing a scheme whereby banks write down mortgage loans to eliminate negative equity in return for a government guarantee on the lower principal.

More radical initiatives are possible. After the late 1980s savings and loan crisis, the US government set up the Resolution Trust Corporation to acquire and sell at a discount assets of failed S&L institutions.

However, such solutions are unlikely to involve bad assets coming on to central banks’ balance sheets, to be financed by printing money. The Fed did not acquire assets of failed S&Ls in the early 1990s. Mervyn King has made it clear that, while the Bank of England is prepared to increase its lending to banks against less liquid collateral, the credit risk of the underlying assets will remain with the banks themselves. The Bank has also been “sterilising” the impact of such lending.

Global money growth is currently very strong and is lending support to commodity prices but I doubt there will be a further boost from the mechanism you suggest.

Claims have recently been made that a 10% fall in house prices would plunge three million households into negative equity.

In the early 1990s housing market downturn, when house prices on the Halifax measure fell by 13% from peak to trough, negative equity is estimated to have affected about 1.5 million households. Loan to value ratios in the 1980s housing boom were higher than in recent years.

A 10% fall in house prices would return them to their level in spring 2006. Four million new mortgages – both loans for house purchase and remortgages – have been extended since March 2006. Fewer than one million of these mortgages will be on an original loan-to-value ratio of more than 90%. (Even Northern Rock kept the share of 90%+ LTV loans below a quarter in 2006 and 2007.) A significant proportion of this one million would remain in positive equity even if prices fell 10% (e.g. borrowers who purchased or remortgaged in 2006 on LTVs close to 90%).

In a recent speech, MPC member Kate Barker referred to Bank of England calculations indicating 5% of mortgagors would be in negative equity in the event of a 15% fall in house prices. (The analysis is based on the 2007 NMG Research survey of household finances.) With 11.8 million mortgages outstanding at the end of 2007, this implies about 600,000 households. With a 10% decline, the figure would be less than half a million.

Benign liquidity conditions failed to prevent a sell-off in stocks last quarter as risk appetite deteriorated in response to ongoing credit market deterioration and an associated downward revision to expectations for economic activity and earnings.

The interplay of liquidity and risk appetite is illustrated by the chart below, showing “excess” money growth in the Group of Seven (G7) economies (i.e. the gap between annual expansion rates of the real broad money supply and industrial output) and a measure of risk aversion based on the VIX options volatility index. Stocks tend to perform well when excess money growth is positive and the risk measure is close to or below zero. Sharp rises in risk aversion neutralise or outweigh the impact of positive liquidity – in effect, the velocity of money falls and liquidity is temporarily “frozen”. Historically, however, periods of intense risk aversion rarely last more than about six months. The current episode is mature and recent additional official actions to stabilise credit markets may lead to a revival in risk appetite over the rest of 2008, allowing stocks to rally.

This assessment is subject to two caveats. First, the G7 excess money measure is biased upwards currently by “reintermediation”, i.e. the rerouting of financial flows through the banking system due to the collapse of off-balance sheet vehicles. One way of adjusting for this effect is to expand the monetary definition to include commercial paper used to finance such vehicles. This suggests “true” G7 excess money expansion of 4-5% rather than 6-7% – still significantly positive.

Secondly, while investor fear levels should abate, a return to risk-loving behaviour in equity markets is unlikely against the backdrop of slowing global economic activity and likely further downgrades to earnings estimates.

My ECB-ometer forecasts the monthly policy decisions of the European Central Bank based on 12 economic and financial inputs. The output is in the form of a projected interest rate change and may be thought of as the average recommendation of the 21 Governing Council members. Since the ECB moves official rates in quarter-point steps, a forecast of above +0.125% or below -0.125% is needed to generate a prediction of a policy change. The chart below shows historical performance.

Last month the model forecast was -0.10% – above the trigger level for a rate cut but suggesting economic and financial developments warranted an easing bias. There was no hint of any such bias in the policy statement delivered at last month’s press conference, which repeated the mantra about upside risks to price stability and a need to “monitor very closely all developments”.

This month the forecast has risen to -0.05%, implying economic and financial conditions are slightly less conducive to an early cut but still argue for some easing of the policy stance relative to recent ECB statements. The change since last month is mainly due to a further rise in inflation.

While there is little prospect of a cut next week, some adjustment to the policy statement is possible, involving a reference to increasing downside risks to growth to balance upside inflation risks. Barring such an adjustment, a reduction in rates in May, as suggested earlier, looks unlikely.

• Northern Rock’s borrowing from the Bank of England stood at £28.5 billion at the end of 2007, not £26.9 billion as widely reported. The larger figure includes £1.5 billion of funding obtained in the Bank of England’s open market operations (OMO) – probably the auction of three-month funds against a wider definition of eligible collateral conducted on 18 December.

• Movements in “other assets” on the weekly Bank of England Return suggest direct borrowing increased further in the first few weeks of the year, when Northern Rock’s future was in limbo. Rock may also have obtained additional OMO funding in a second auction of three-month funds on 15 January. So total support is likely to have peaked at about £30 billion, as seemed likely last autumn.

• Northern Rock’s restructuring plan shows government funding – excluding OMO loans – falling to just £1 billion by the end of 2009. This is consistent with the analysis here, indicating borrowing might be repaid surprisingly quickly.

• The Treasury is more cautious than Northern Rock about the repayment schedule. The Chancellor has set a deadline of the end of 2010 for full repayment and the Budget projected direct support at £14 billion at the end of the 2008/9 financial year. This caution may reflect doubts that other banks will be able to accommodate mortgage borrowers switching from Rock given the current difficult funding environment.

• The ability of other lenders to assume Northern Rock’s loans will depend partly on the nature and size of new longer-term financing facilities promised by the Bank of England to alleviate the funding crisis. The more generous the facilities, the more plausible Rock’s forecasts of rapid repayment will look.

• The penalty rate being paid by Northern Rock on its non-OMO borrowing appears to be one percentage point above Bank Rate. Note 28 to Rock’s accounts states that the margin above Bank Rate includes an “element of fixed PIK interest margin” (PIK = payment in kind, i.e. interest rolled up into a further debt). Note 34 gives a figure of £40.9 million for this PIK interest at the end of 2007. This interest accrued over the final four months of 2007. Assuming borrowing averaged £12 billion over this period, this would imply an annualised interest rate of about one percentage point ( 100 x ( 40.9 x 12 / 4 ) / 12000 ).

• The recent flow of cash back to Northern Rock, reflected in a fall in its Bank of England borrowing, has probably aggravated funding pressures faced by other banks, contributing to a rise in interbank interest rates. The Bank of England has cast doubt on such an effect, arguing that “the impact on the money markets of any flows of cash back to the Bank of England from Northern Rock is routinely offset in the Bank’s weekly market operations.” This may miss the point, however. Banks suffering an outflow because of Northern Rock are unlikely to regard the weekly repo facilities as a substitute. The form in which official funds are supplied to the market is an important influence on interbank interest rates. The Bank has replaced a longer-term loan against mortgage collateral with short-term lending against government securities. Banks are struggling to secure long-term funding at present so the substitution is likely to have contributed to upward pressure on term interbank rates.

Late last year my US recession probability indicator rose to 45%, suggesting the economy would come close to but just skirt a downturn (as defined by the National Bureau of Economic Research).

Since then the credit crisis has intensified and soaring commodity prices have taken a further chunk out of real incomes. Most forecasters believe a recession has started and some expect it to be deep. Yet the data still leave room for debate.

Available evidence suggests GDP may eke out a small gain in the first quarter. Based on February numbers released today, personal consumption should be flat at worst. Housing investment will again be a significant drag but should be neutralised by stronger net exports. Other capex is likely to be little changed and stockbuilding should be positive. Annualised growth of 1% or so does not look out of the question.

A key reason for thinking a recession has started is a fall in private payrolls over the last three months. A further decline in March numbers released next Friday would be difficult to ignore but a rebound should not be ruled out. Weekly unemployment claims have yet to cross the 400,000 level to be expected in a serious labour market decline, while the excellent Trim Tabs point out that withheld tax receipts have picked up in recent weeks, suggesting conditions have at least stopped deteriorating.

Remember that fiscal policy is set to be a significant positive for the economy from May, when tax rebate cheques start to be mailed out.

The recent rise in interbank interest rates reflects a clash between expanding bank funding needs and a fixed level of longer-term Bank of England lending against private sector collateral – see yesterday’s post.

The pressure may, however, have been aggravated by a flow of cash back to Northern Rock .

Other banks benefited from Northern Rock’s woes last autumn, as savers withdrew funds from the troubled lender and redeposited them elsewhere. Now, the reverse flow is occurring, with savers lured back by attractive rates and government guarantees and Rock’s mortgage borrowers encouraged to refinance with other lenders.

Rather than lend its surplus cash back to other banks in the interbank market, Rock has reduced its borrowing from the Bank of England . The Bank of England weekly Return suggests the Rock loan has fallen from a peak of £27 billion in January to £21 billion currently.

The Bank of England should increase longer-term lending to the market to offset the liquidity drain from Northern Rock.