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The co-ordinated liquidity operation announced by central banks yesterday is promising but questions remain about its implementation. The market response has been muted: three-month dollar LIBOR was fixed just 7 bp lower this morning, while the corresponding euro rate was unchanged.

The Fed’s new “term auction facility” is modelled on the ECB’s three-month repo operations, although the first two auctions will be of shorter maturity (28 and 35 days). The key features are 1) a non-penal, market-determined interest rate, 2) acceptance of a broad range of collateral and 3) borrower anonymity.

However, the ECB’s auctions have not been reflected in greater success in reducing Eurozone LIBOR premiums compared with those in the US and UK. The reason is simple: the ECB has offset its additional three-month lending by cutting back funds supplied in shorter-term operations. Banks’ reserves at the ECB have shown little change since the onset of the liquidity crisis.

The success of the new operations therefore depends on them being used to increase aggregate central bank lending to the banking system, not just extend the maturity of existing support. The outcome will be unclear until after the auctions take place, partly explaining the market’s muted response.

One curious feature of the operation is that the ECB will offer dollars to European banks but is not planning additional euro lending. This explains the failure of euro LIBOR rates to match the modest declines in dollar and sterling rates.

Back in October I suggested US housing market pessimism was overdone and activity was probably bottoming. The jury is still out but home sales edged higher in September and October – see first chart. One hopeful sign was an improvement in the home-buying conditions index from the University of Michigan consumer survey. As the chart shows, this indicator rose further to a seven-month high in early December.

Weekly mortgage applications for house purchase have recovered to their highest level since January  – see second chart. There are well-known problems with this series – it is biased towards prime borrowers and may be distorted by people making multiple applications – but the recent upward trend is encouraging.

The collapse in home sales from mid 2005 was preceded by a sharp drop in the housing affordability index calculated by the National Association of Realtors. This index bottomed in mid 2006 and has recovered significantly since the summer, reflecting lower home prices and a large decline in mortgage rates for prime borrowers – see third chart.

Construction indicators have yet to show improvement but the NAHB homebuilders index stabilised in November – December’s survey is released next week. While still high, inventories of unsold new homes have been falling for over a year, reaching a 22-month low in October. Homebuilders’ stock prices tend to lead housing starts and may be in the process of forming a bottom. As the final chart shows, a recent rally in the S&P homebuilding index broke the downtrend in place since the summer and prices are now retesting the trend line from above. It would be encouraging if the index finds support at the line; a renewed fall below would signal new lows ahead.

Numerous commentators – including Bank of England Governor Mervyn King – have expressed surprise at the resilience of equity markets given the significant risk of a global “hard” landing. My attempt at an explanation goes as follows.

As I have noted before, G7 industrial output growth peaked at an annual 4.5% in September 2006, marking the start of the current economic downswing. 12 prior downswings in G7 industrial growth can be identified over the last 40 years. Six were associated with US recessions, as defined by the National Bureau of Economic Research – “hard” landings. The remaining six can be termed “soft”.

Unsurprisingly, global equity markets tend to perform well in soft landings and badly in hard landings. I calculated an index of average performance starting from the cyclical peak in G7 industrial growth for each of the two groups. I then superimposed these averages on the current cycle – see chart.

Global equities have so far followed the historical soft landing path closely. Does this imply that markets are irrationally ignoring the significant risk of a hard landing? Not necessarily. If the current downswing does indeed turn out to be soft, the historical average would suggest a further rise in equities of 20% from closing November levels by the end of 2008. If a hard landing transpires, a fall of 13% is indicated. The resilience of equities may therefore partly reflect market participants’ assessment that the potential gain in a favourable economic scenario exceeds the loss in the event of a US recession / hard landing.

Based on recent economic evidence, it seems reasonable to assign 60% / 40% probabilities to soft / hard landings at present. Using the historical averages shown in the chart, this would imply a probability-weighted price change between November’s close and the end of 2008 of +7% (i.e., 0.6*20 – 0.4*13). Adding on dividends gives an expected return of 9%. This compares favourably with cash rates and likely bond performance.

Equity markets will clearly weaken if the probability of a hard landing increases further but current price levels are defensible based on the latest economic indicators.

The ECB expects “sustained real GDP growth broadly in line with trend potential”, according to the statement released after yesterday’s policy meeting. They are either in denial or – more likely – talking tough because of near-term inflation concerns.

Key leading indicators have deteriorated sharply in recent months. As an example, business expectations in the services sector purchasing managers’ survey has fallen to its lowest since November 2002. Historically, the ECB has been cutting rates when this series has been at current levels – see first chart.

Spain looks increasingly at risk of a nasty recession. Residential investment accounts for over 7% of real GDP and housing construction approvals fell 51% in the third quarter from a year before – see chart. Monetary trends are also alarming, with inflation-adjusted narrow money now contracting on an annual basis (see also here).

My ECB-ometer suggests a neutral policy stance is now warranted by incoming data. The hawkish rhetoric looks increasingly unconvincing.

Amid all the gloom and doom, here are some reasons for thinking US consumer spending is not about to collapse:

1. Vehicle sales – normally sensitive to shifts in consumer sentiment – held steady at a 16.2 million annualised rate in November, in line with the year-to-date average.

2. Withheld employment tax receipts – a good real-time indicator of incomes – rose at a respectable 5.3% annual pace in October / November.

3. Layoff announcements have remained broadly stable in recent months – November’s total was down 5% from a year before.

4. Mortgage applications have picked up in response to a steep fall in mortgage rates for non-jumbo prime loans, with the four-week moving total at its highest since 2005.

5. Reflecting lower house prices as well as mortgage rates, the National Association of Realtors’ housing affordability index has also recovered to a two-year high.

6. Retail gasoline prices have started to come down in lagged response to lower wholesale prices, which are back at mid-October levels.

7. Wal Mart’s share price has perked up recently and usually correlates well with short-term swings in retail sales – see chart.

While ongoing money / credit market stresses are concerning, my indicators suggest the odds currently remain against a US recession.

Market participants are discussing reports of a massive contraction in sterling interbank lending activity since the onset of the “credit crunch” in August. According to Bank of England figures, the outstanding value of UK banks’ market loans to other UK banks fell from £640 billion at the end of August to £249 billion in September and £186 billion in October (see here, P44, bottom panel). However, the figures have been distorted by two major banking groups – apparently HBOS and Bank of Ireland – consolidating the reporting of their subsidiaries. Intra-group lending between these subsidiaries was previously included in the Bank’s series for total interbank loans but is now being netted out. According to the Bank’s statisticians, after adjusting for such “changes in the reporting population” interbank lending has contracted by only £3 billion – not £454 billion – between August and October (see top panel in above table).

Our MPC-ometer model suggests a narrow 5-4 vote in favour of a 25 b.p. rate cut this week but the argument that easing is needed to offset a seizure of interbank lending activity is a red herring.

Our MPC-ometer model suggests a narrow 5-4 vote for a 25 b.p. cut at this week’s meeting. According to a Reuters poll, only 15 of 56 economists expect a change this month. However, the Sunday Times Shadow MPC has voted 5-4 to ease, with four of the majority group seeking a move of 50 b.p. or more.

There are three main reasons for expecting a change. First, the November Inflation Report was dovish, with the MPC’s inflation and growth forecasts reduced significantly from August. Assuming unchanged 5.75% official rates, inflation is now projected at 1.74% in two years’ time, down from 2.08% in August. The 26 b.p. shortfall from the target is the largest negative deviation in any Inflation Report since the MPC’s inception in 1997. The alternative scenario based on market expectations shows inflation on target in two years assuming a 50 b.p. rate cut by the third quarter of 2008. Meanwhile, annual GDP growth is forecast to fall from an estimated 3.5% last quarter to just 1.9% by the third quarter of 2008, down from 2.6% in the August Report.

Secondly, economic news since the November meeting has been slightly weaker than expected on balance. GDP growth in the third quarter was revised down from 0.8% to 0.7%, with the details showing stagnant business investment – previously expanding strongly – and a large rise in stocks. Housing market indicators continue to soften: the four main price indices have all now registered monthly falls, while mortgage approvals for house purchase slumped 30% by value in October from a year before. Exports are at risk from slowing demand in continental Europe, with the latest Eurozone purchasing managers’ survey showing new business at a two-year low.

Thirdly, money and credit markets have weakened significantly since the November meeting. A Merrill Lynch index of yields on sub-investment-grade UK corporate bonds has risen by 50 b.p. since 8th November, breaching 10% for the first time since 2003. The key three-month interbank rate has climbed 35 b.p. over the same period and currently stands at an 80 b.p. premium to Bank rate, the highest since Northern Rock imploded. Longer-term rates have risen by considerably less (six-month is up by 20 b.p.), suggesting the surge in the three-month rate partly reflects year-end funding pressures and may therefore prove temporary. Nevertheless, financial conditions are clearly tighter than assumed when the MPC finalised its forecasts, arguing for bringing forward official rate cuts that the Inflation Report indicated would be needed in due course.

The vote is likely to be close because inflation indicators are currently still flashing warning signals. Consumer inflation expectations and price-raising plans in business surveys remain elevated, while energy price gains have contributed to a sharp acceleration in producer input costs. Regular pay growth appears subdued at an annual 3.7% in the three months to September, according to the traditional average earnings index measure, but the alternative average weekly earnings series is significantly higher, at 4.7%. Exchange rate weakness is also a concern, with the effective rate down by nearly 2% since the Inflation Report forecast was finalised. However, the MPC has historically been prepared to ease policy despite unsatisfactory inflation indicators if activity data and / or financial market conditions have shown sufficient weakness. The MPC-ometer combines the various factors using weights derived from an analysis of past decisions and suggests the balance has now tipped in favour of action.

UK high-street spending has proved resilient in recent months and retailers remain moderately optimistic about near-term prospects, according to the November CBI distributive trades survey. However, a significant slowdown is now being signalled by our leading indicator – see chart below. The indicator has five components: mortgage approvals, real earnings growth, retailers’ sales assessment, consumer buying intentions and household sector real money growth. Recent weakness mainly reflects drops in mortgage approvals and buying intentions coupled with lacklustre real earnings growth.

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.