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Why have interbank interest rates climbed sharply in recent weeks? The conventional view is that the increase reflects heightened concern about counterparty risk, partly due to the Bear Stearns crisis. However, an alternative explanation is that banks have exhausted the longer-term liquidity support provided by the Bank of England in tandem with other central banks around the turn of the year and are again scrambling to secure funding in the interbank market. This would suggest a need for a further expansion of such “lender of last resort” operations – a possibility now reluctantly being considered by the Bank of England.

The alternative explanation is supported by evidence that UK banks have continued to securitise and off-load loans in large volumes in recent months. According to Bank of England data, £29 billion of securitised lending to the UK private sector was removed from balance sheets in the seven months from August to February – only modestly down from £37 billion in the first seven months of 2007, before the financial crisis broke (see chart). Market demand for such paper has been non-existent since the summer. Instead, the securities are likely to have been used as collateral to obtain longer-term funding from the Bank of England and ECB.

The Bank maintained a strict definition of eligible collateral in the early stages of the crisis but relented to market demands and accepted triple-A-rated asset-backed securities in auctions to allocate £20 billion of three-month funds in December and January. This allowed banks to off-load their securitised paper and contributed to a sharp fall in term interbank rates in the first few weeks of the year. However, the relief has proved temporary as credit expansion has remained robust in early 2008, further boosting banks’ funding needs. The Bank is rolling over the December / January facilities but has not yet announced an increase in their size.

The gap between the £29 billion of securitised loans removed from balance sheets between August and February and the current £20 billion Bank of England limit on ABS collateral supports claims that UK banks have also been accessing ECB funds, either via Eurozone subsidiaries or by arrangement with facilitator banks. Indeed, the ECB may have been the first port of call given that it accepts collateral rated down to single A as long as securities are senior within the credit structure.

If the above explanation is correct, the Bank of England faces a difficult choice in responding to current market pressures. It can follow the recent example of the Federal Reserve and expand support operations significantly; as in December / January, this would probably be effective in lowering interbank rates but at the cost of a semi-permanent increase in banks’ reliance on official funding and associated “moral hazard” risks. Alternatively, it can refuse to bridge the funding gap created by continued solid lending growth, forcing banks to restrict credit availability further, with possibly major negative economic implications. In theory, the impact could be offset by cuts in official interest rates but achieving the right balance would be problematic, particularly against the backdrop of above-target and rising inflation.

The Fed influences the economy and markets by setting official rates and expanding or contracting its own balance sheet. Attention tends to focus on the former but balance sheet trends sometimes convey important additional information.

While the Fed slashed official rates in late 2007 and early 2008, Federal Reserve Bank credit – a key balance sheet measure – contracted. This suggested policy was not sufficiently expansionary to offset deteriorating economic and market trends.

The Bear Stearns crisis has forced the Fed to inject more cash – Fed credit jumped by $10 billion in the week to last Wednesday. An additional $20 billion was lent under the Term Auction Facility, $13 billion under the new Primary Dealer Credit Facility and $6 billion in connection with the J P Morgan-Bear Stearns transaction. The Fed partially offset these injections by selling $32 billion of securities from its own portfolio.

These changes have pushed the three-month growth rate of Fed credit to its highest since November – see chart. The Fed could yet sterilise recent and future cash injections, returning the balance sheet to its prior path. However, a continuation of the recent pick-up would be a strongly positive signal for economic and market prospects later in 2008.

“Other assets” on the Bank of England’s balance sheet have fallen in each of the last four weeks and are now £4.8 billion below a peak reached in late January. The most likely explanation for the decline is that Northern Rock is repaying its loan from the Bank as it enjoys a cash inflow from redeeming mortgages and savers attracted by its competitive rates and the unlimited government guarantee. If correct, this would support analysis suggesting Rock will pay back its loan much earlier than the three to four year horizon indicated in its business plan released this week (see here).

The Fed had announced a significant expansion of its liquidity support operations even before the Bear Stearns crisis broke. By contrast, aside from minor fine-tuning, the facilities offered to UK banks by the Bank of England have remained unchanged despite a steady climb in interbank rates in recent weeks, with three-month LIBOR fixing yesterday at 5.98%.

The Bank’s inertia reflects a view that interbank rates are rising because of heightened concern about counterparty credit risk rather than a shortage of liquidity. This is illustrated by a chart on page 11 of the latest Quarterly Bulletin (page 13 of the PDF), purporting to show that the liquidity or non-credit premium in current term spreads is negligible. Bank officials are therefore sceptical that expanding money market operations would have much impact; their inaction may also be informed by Mervyn King’s view that markets were previously underpricing risk so rising credit premia should not be resisted.

The flaw in this analysis is that credit risk and illiquidity are inextricably linked, as Paul De Grauwe argues on page 13 of today’s Financial Times. Northern Rock was and is solvent but its liquidity crisis resulted in significant losses for holders of its more junior debt. Market concerns that selected institutions will be unable to obtain funding are likely to have resulted in credit risk premia overshooting levels implied by solvency considerations.

Bank chiefs are reportedly meeting with Mervyn King today to ask for an expansion of liquidity support. That they have been forced to lobby publicly for such action suggests the Bank of England remains out of touch with markets and has failed to learn the lessons of Northern Rock.

1. The Fed has effectively pledged its own balance sheet to prop up markets. There is no limit to the cash the Fed can print and its solvency is guaranteed by the US government’s tax-raising authority.

2. Global liquidity is plentiful, with G7 broad money growth running at over 11% pa – a 26-year high. Investors are currently frozen in the headlights but will rush to deploy cash as it becomes clear that financial armageddon will be avoided.

3. Equity markets are discounting a recession – their performance since the current economic downswing began in September 2006 matches an average of six prior hard landings. Bears need to believe that a recession is not only certain but will be unusually severe.

4. A hard landing may yet be avoided. The impact of tighter credit is counterbalanced by a significant easing of monetary conditions and US fiscal stimulus worth over 1% of GDP, with tax rebates due to hit pay-packets from May.

5. Corporations have been cautious about expanding employment and investment in recent years and are not yet under strong pressure to retrench. Emerging world resilience is a further bulwark against a severe economic downturn.

6. Investor pessimism is extreme – the CBOE put / call ratio has spiked above levels at prior US market lows, including 1998, 2002 and 2003, while bears outnumber bulls by the widest margin since 1990, according to the American Association of Individual Investors. US-based equity mutual funds have suffered a $21 billion outflow so far in March, according to Trim Tabs.

7. While retail punters are bailing, US corporate insiders have stepped up buying, suggesting they see value in their shares and do not expect a wrenching recession. InsiderScore.com’s buy / sell ratio has surged well above levels at recent market lows – see here.

8. Losses on US subprime mortgages have been largely accounted for. According to S&P, write-downs on subprime ABS could reach $285 billion, of which well over $150 billion has been disclosed. The $285 billion estimate far exceeds projected credit losses of $136 billion on underlying loans, reflecting both the creation of synthetic subprime exposure and distressed pricing. For synthetic subprime, losses for some participants are balanced by gains for others, while write-downs due to distressed pricing should eventually be reversed.

9. The magnitude and duration of the fall in US financial shares is comparable with the decline associated with the savings and loan crisis of the late 1980s. Financials are now trading on a larger price-to-book discount to other sectors than at the 1990 trough.

10. The G7’s malign neglect of the dollar now represents the key risk for markets. The Fed’s excessive interest rate cuts coupled with ECB / BoJ intransigence have prompted a flight of capital out of the US, exacerbating financial stresses. An associated surge in commodity prices has undermined efforts to stimulate the economy.

My fears that the lack of a coordinated G7 response to worsening credit conditions and a tumbling dollar would push markets to a “riot point” appear to have been borne out by recent events, culminating in the sad demise of Bear Stearns.

To recap, the Fed’s panic rate cuts have been counterproductive in terms of restoring market stability, because they have triggered a flight of capital out of the dollar at a time when US financial institutions face severe funding difficulties. Other G7 central banks, led by the ECB, have contributed to the mistake by refusing to ease their own policies, thereby increasing pressure on the Fed and presenting dollar bears with an open goal.

Over the last 10 days the Fed has announced measures to provide an extraordinary $382 billion* of additional financial support – equivalent to 2.7% of annual GDP. Markets are also fully discounting a further 100 bp cut to 2.0% in the Fed funds rate target at tomorrow’s FOMC meeting.

The scale of this commitment should not be underestimated and there is little doubt that the Fed will take further action if required. The effects may, however, remain disappointing without a coordinated G7 effort to stabilise the dollar, involving policy rate cuts by the ECB and Bank of Japan and the Fed moving to the sidelines, at least temporarily.

_{* Breakdown as follows: increase in Term Auction Facility $40 billion, increase in conventional term repos $100 billion, new Term Securities Lending Facility $200 billion, increase in foreign exchange swaps with other central banks $12 billion, special facility provided to J P Morgan related to acquisition of Bear Stearns $30 billion.}

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EXCERPT:
Breakdown as follows: increase in Term Auction Facility $40 billion, increase in conventional term repos $100 billion, new Term Securities Lending Facility $200 billion, increase in foreign exchange swaps with other central banks $12 billion, special facility to J P Morgan related to acquisition of Bear Stearns $30 billion.

According to the Case-Shiller national index, US home prices peaked in the second quarter of 2006 and had fallen by 10% by last year’s final quarter. By contrast, the Office of Housing Enterprise Oversight (OFHEO) purchase-only index was essentially unchanged over the same period. Why the divergence?

Both indices are based on a repeat-sales methodology. They use different underlying data – deed records of residential sales transactions in the case of Case-Shiller and mortgages purchased by Fannie Mae and Freddie Mac in the case of the OFHEO – but the most likely explanation for the divergence is that the Case-Shiller index is value-weighted, so is more affected by price movements of expensive housing.

This difference in construction implies that Case-Shiller should be a better guide to changes in aggregate housing wealth but OFHEO is more representative of the price experience of the typical home-owner.

The chart below compares the two indices over a longer time-frame. Recent weakness in the Case-Shiller index is the counterpart of much greater strength during the boom period. Case-Shiller climbed 69% in the five years to the second quarter of 2006, while OFHEO was up 47%. Even after its recent hefty drop, Case-Shiller is still ahead of OFHEO since the latter’s inception in 1991.

Bears argue that the loss of wealth implied by Case-Shiller will prompt significant consumer retrenchment. If OFHEO is correct in suggesting the average home-owner has so far experienced only a modest decline, however, the effect could be smaller than feared. OFHEO would also suggest a lower estimate of the number of households currently in negative equity.

The Budget was a non-event in macroeconomic terms. The Chancellor’s strategy is to allow borrowing to take the strain of a weaker economy this year in the hope that growth rebounds solidly in 2009 and beyond. This may well be appropriate but claims that the fiscal rules are still being met look increasingly untenable.

Key points:

1. The Budget is broadly revenue neutral in 2008/9 but raises £1.9 billion by 2010/11, mostly via increases in alcohol, fuel and vehicle excise duties.

2. Public sector net borrowing is now projected at £43 billion in 2008/9, up from £36 billion in the Pre-Budget Report, reflecting the impact of slower growth and financial market turmoil on tax receipts.

3. General government net borrowing is forecast at 3.2% of GDP in 2008/9 – above the 3% Maastricht treaty limit.

4. Mid-point GDP growth projections have been revised down by a quarter of a percentage point in 2008 and 2009, to 2.0% and 2.5% respectively. 2010 is unchanged at 2.75%.

5. As usual, the claim that the Golden Rule will be met over the cycle relies on a projected sharp improvement beyond the coming fiscal year, based on a rise in the tax share of GDP as well as faster economic growth.

6. One surprise is that net gilt issuance is projected to surge from £29 billion in 2007/8 to £63 billion in 2008/9. As well as higher net borrowing, this reflects a transfer of the Northern Rock loan from the Bank of England to the Treasury and repayment of the Bank’s historical “Ways and Means Advance” to the government.

7. The transfer of the Northern Rock loan is required to comply with EU restrictions on central bank lending to government entities. The loan is projected to fall to £14 billion by March 2009, implying a reduction of £11 billion from its current estimated level of £25 billion. It is striking that even the Treasury, which has every reason to be conservative, projects a significant repayment by early next year.

Northern Rock could be in a position to repay most its loan from the Bank of England by early next year. Here’s how.

First, consider the Granite securitisation vehicle. According to documentation on Rock’s website, on 31 March 2007 Granite held £16 billion worth of fixed-rate mortgages with resets occurring in 2008. Rock is offering unattractive rates to refinance, while its standard variable rate is a high 7.59%. Any borrowers able to switch to other mortgage lenders are likely to do so. Let’s assume £13 billion of Granite mortgages are repaid in 2008.

Granite expects to repay principal of £9 billion on its outstanding notes in 2008. If £13 billion flows back from mortgages, this leaves a surplus of £4 billion. My understanding is that Northern Rock is able to extract this surplus by injecting mortgages from its own book into the Granite pool.

Rock’s non-Granite mortgages totalled £38 billion on 30 June 2007 so there would seem to be no obstacle to extracting surplus cash from Granite, even if new mortgage business is negligible, as seems likely. Moreover, a portion of these non-Granite mortgages will also be repaid this year. Assuming the same profile as for the Granite pool, £11 billion could be fixed-rate deals resetting in 2008. Let’s say £9 billion of non-Granite mortgages are repaid this year. Adding this to the £4 billion Granite surplus gives a total inflow of £13 billion.

Now consider funding. Rock had £24 billion of retail deposits on 30 June 2007 but at least half left the bank after it was forced to seek emergency funding from the Bank of England. Post-nationalisation, savings are returning in response to high interest rates and the unlimited government guarantee. (Savers were previously deterred by the risk of accounts being frozen if the bank entered administration.) Even after a recent cut, Rock’s tracker online and silver savings accounts offer a highly competitive 6.25%. If this edge is maintained, retail inflows of £10 billion or more look possible this year. (Landsbanki’s ICESAVE attracted £5 billion in the 15 months to 31 December 2007 from a standing start and without the benefit of a government guarantee.)

Adding a £10 billion deposit inflow to mortgage repayments of £13 billion would leave Rock only £2 billion short of the estimated £25 billion Bank of England loan.

What could go wrong with this scenario? One risk is that other lenders will be unable to accommodate borrowers switching from Rock given the current difficult funding environment. Perhaps this partly explains government measures announced last week designed to restart the market for mortgage securities.

Similarly, concerns about unfair competition or the stability of other institutions relying on retail funding may force Rock to cut its deposit rates, implying a smaller savings inflow.

Rock could also decide not to pay the Bank of England back so soon, even if it has the resources. It may wish to continue to generate new mortgage business, albeit on a much smaller scale than in recent years, in order to maximise its attraction to an eventual purchaser. Also, the Bank loan represents cheap funding, at least when considered from the perspective of the public sector as a whole. The Bank of England effectively pays Bank rate on the money it creates to lend to Rock. At 5.25%, this is a full percentage point below the rates Rock currently offers on its leading savings products.

Friday’s weak payrolls numbers are widely viewed as confirming that the US economy is in a recession. I think they are consistent with a flat economy. A recession may be coming but it has yet to be confirmed.

A recessionary labour market is characterised by a fall in hiring and a rise in layoffs. So far only the former has occurred. Layoff announcements have been stable in recent months – see chart. This is why weekly initial claims for unemployment insurance have yet to reach the 400,000 level that would signal a recession.

Interestingly, Manpower chairman and chief executive Jeffrey A. Joerres made the same point when commenting on his firm’s latest hiring survey, showing the weakest US jobs outlook for four years. “The important change is not about reductions in workforces, like we would expect in a recessionary period, but rather an increase in the percentages of employers who are planning to put a hold on hiring.”

According to the payrolls report, aggregate weekly hours worked in the private nonfarm economy contracted at a 1.7% annualised rate in January / February from the fourth quarter. This could still be consistent with stable or expanding output, given that productivity has recently been growing at a 2% pace.

The worsening credit crisis and soaring food and energy costs have increased near-term risks but there is substantial monetary and fiscal stimulus in the pipeline. The economy may yet muddle through. Wait for layoffs and initial claims to rise before accepting recession orthodoxy.