Similarly to Japan, bad assets have choked off the supply of credit in the current U.S. financial environment. Interbank lending rates (e.g. LIBOR) are abnormally high, especially compared to T-bill yields, manifested in the extreme highs of the TED spread. This flight to safety demonstrates extremely risk-averse behavior by banks. Banks do not want to lend to each other or to businesses because they fear defaults, just as the cost of credit default swaps (CDS), which insure lenders against defaults by borrowers, skyrockets.
E. Silvia, Ph.D. Chief Economist, Wachovia
Vicious Circles
Stephen Roach, Head Economist, Morgan Stanley
Despite a sharp rise in the unemployment rate, US employment has declined only modestly so far in the current economic slowdown. That is giving comfort to those who believe that the economy will avoid recession. The reasoning: Modest job losses mean that consumer incomes will weather the storm, sustaining consumer spending. Such comfort is misplaced, in my view; job growth won’t hold up in the face of a slipping economy. In fact, at least two 'adverse feedback loops' threaten to turn the mild recession we have called for into one that is severe. One involves spreading weakness beyond housing to consumer and capital spending, and from a global slowdown to US exports, which will promote further declines in employment, in turn pressuring income, consumers and their lenders. A second vicious circle runs from tighter credit to a weaker economy, and to a deterioration in credit quality, in turn increasing reluctance to lend. Both threaten an economy now on the brink. Thus, in my view the issue now is not whether a recession is likely, but how deep it will be and how long it will last. Full Story How Fat is the Tail? Niels-Henrik Bjørn Sørensen, Senior Analyst, Danske Bank Economic numbers in the past week have been alarmingly weak. Manufacturing PMI activity indices are collapsing the world over: in the UK it fell to 41, in Sweden to 42.3, in France to 43, in the USA to 43.5 and in Ireland to 43.7. Remember that anything below 50 indicates a slowdown and levels below 45 are usually only seen in conjunction with a recession. In Japan, industrial production fell 6.9% y/y. However, it is not just industry that is exhibiting weakness. Euroland unemployment rose for the third straight month and has now risen in four out of the past five months. House prices in the UK and the US fell record-fast (down 12.4% and 16.3% y/y, respectively). Only China managed a positive surprise, as its PMI rose to 51.2. The conclusion is relatively simple: the US would have to be lucky to avoid a recession, Japan is on the brink of one, and a recession in Euroland now looks inevitable. Hence, the outlook for a large chunk of the global economy remains rather negative. Full Story Taking Down the Credit Crunch E. Silvia, Ph.D. Chief Economist, Wachovia
Full Story
How Fat is the Tail?
Niels-Henrik Bjørn Sørensen, Senior Analyst, Danske Bank
Economic numbers in the past week have been alarmingly weak. Manufacturing PMI activity indices are collapsing the world over: in the UK it fell to 41, in Sweden to 42.3, in France to 43, in the USA to 43.5 and in Ireland to 43.7. Remember that anything below 50 indicates a slowdown and levels below 45 are usually only seen in conjunction with a recession. In Japan, industrial production fell 6.9% y/y. However, it is not just industry that is exhibiting weakness. Euroland unemployment rose for the third straight month and has now risen in four out of the past five months. House prices in the UK and the US fell record-fast (down 12.4% and 16.3% y/y, respectively). Only China managed a positive surprise, as its PMI rose to 51.2. The conclusion is relatively simple: the US would have to be lucky to avoid a recession, Japan is on the brink of one, and a recession in Euroland now looks inevitable. Hence, the outlook for a large chunk of the global economy remains rather negative.
Taking Down the Credit Crunch
In the early 1990s, Japan’s economy experienced a financial crisis after a bubble burst. Different band-aids were applied to the series of failures that resulted. The sum cost of all of the measures taken to resolve the crisis amounted to 86 trillion yen, about 17 percent of GDP. The prolonged period of stagnant growth and continual financial crisis became known as the lost decade. Similarly to Japan, bad assets have choked off the supply of credit in the current U.S. financial environment. Interbank lending rates (e.g. LIBOR) are abnormally high, especially compared to T-bill yields, manifested in the extreme highs of the TED spread. This flight to safety demonstrates extremely risk-averse behavior by banks. Banks do not want to lend to each other or to businesses because they fear defaults, just as the cost of credit default swaps (CDS), which insure lenders against defaults by borrowers, skyrockets. For banks, liquidity needs cannot be met and wholesale bank runs ensue, in which large depositors withdraw funds in order to fall beneath the amount insured by the FDIC. For corporations that rely on short-term financing, ever-diminishing commercial paper lending forces them to turn to banks. Weak bank balance sheets curtail their ability to provide loans at any rates. A disastrous sequence of economic events ensues. The financial system must be recapitalized and credit markets unfrozen. Banks need to purge their bad assets and free up space on their balance sheets to begin lending anew. Huge sums of money are certainly required. Maybe the fast band-aid removal approach is best—it might sting now but it’s better than the prolonged pain of a lost decade.
Bailout Blues
Steve Chan, Economist, TD Bank Financial Group
The workings in Washington on the Treasury’s bailout plan are now into their third week. With both parties' leadership in agreement on the terms of a bailout package, this week it was a matter of getting Congress to sign on. The first attempt in the House failed quite miserably and officials were sent scrambling to re-work the plan in time to get it passed by the Senate. That was accomplished on Wednesday and with sweeteners added to the bill, the House of Representatives voted in favour of it early Friday afternoon. It couldn’t have come a moment too soon. Since Monday, credit spreads have continued their astronomic rise. Short term funding rates to banks, as measured by the London Interbank Lending Rate, rose to 4.33% by Friday morning, pushing the spread over the effective Fed Funds rate more than 200 basis points since the start of September. With funding costs continuing to rise (despite the increased liquidity injections by central banks) the downside risks to real economic growth have increased along with them. Movement on a plan that will bring some semblance of confidence to financial markets is a clear requirement for the move away from the abyss.
Dollar Supported by Weak UK Data and Dovish Comments From ECB President Trichet
Trevor Williams, Chief Economist at Lloyds TSB Financial Markets
US Congressional impasse regarding the details and size of the TARP (Troubled Asset Recovery Programme), President Trichet’s comment that an interest rate cut was discussed as an option at Thursday’s ECB meeting, concerns about European banks' financial health in the wake of the Fortis bailout and a weak set of economic data releases across the board have led to significant currency volatility this week. Over the week as a whole, the US dollar has strengthened by 5.3% against the euro ,which touched a 13-month low of $1.3703. £/$ depreciated 3.5% to 1.7749. However, sterling rose 1.9% against the euro to end at 1.2842. The Japanese yen strengthened close to 5% against the euro, leaving the $/yen cross unchanged, as investors took flight to safety into Japanese assets along with US government bonds. Other East Asian countries with strong trade relationships with Japan, such as the Taiwanese dollar and the Singapore dollar, also strengthened. The high-yielding Australian dollar and the Brazilian real were the worst performing currencies against the majors, partly related to retrenchment in commodity prices, as oil prices fell briefly below $90 a barrel.
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