Weekly Bank Research Center 09-22-08


The Slowdown Goes Global

Stephen Roach, Head Economist, Morgan Stanley

The slowdown that began in the US is going global. It now appears that economies in much of the developed world are slipping towards significantly slower growth, if not outright technical recession. Indeed, our global growth forecasts for both 2008 and 2009, at 4% and 3.5%, respectively, are each 0.1% lower than in July, when we did the last comprehensive update (see Global Forecast Snapshots, September 12, 2008). These annual forecasts mask considerable near-term weakness: In the US, Canada, Europe, Japan and New Zealand, we expect a few quarters of essentially no growth. In our view, the slowdown abroad still doesn’t portend a global recession, but the risks have clearly shifted to the downside. The sources of that weakness will help determine the consequences: If, as many assume, the global slowdown has been primarily the result of the sharp escalation of energy and food prices between March and mid-July, then the equally sharp reversal of those prices should at least cushion the downturn and prevent recession. We agree that the energy shock was one contributing factor, and lower energy prices clearly will help the oil-consuming countries, while lower food quotes will help the net food importers. But soaring energy and food prices aren’t the only story behind the slowdown; far from it. We think that the broader pickup in global inflation is a culprit.


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Giant Trash Can or Just What the Doctor Ordered?

Niels-Henrik Bjørn Sørensen, Senior Analyst, Danske Bank

Currency movements during the week were rather wild once again. The start of the week brought a clear flight to quality, with the CHF and especially the JPY strengthening on the back of the collapse of Lehman Brothers, the last-minute bailout of insurance giant AIG and the nosedive in global equity markets, among other things. However, this was a continuation of an existing negative news flow, and the week ended with more positive news with the potential to boost sentiment in FX markets in the coming weeks, although they are still expected to be highly volatile. US authorities are considering setting up a fund to put a floor under the financial crisis. Based on experience from the Savings and Loan crisis 20 years ago, the idea is to create a fund in which to place assets that the market does not currently want to buy and that constitute loss-making positions on banks' balance sheets. News that such a fund could be on the doorstep was warmly welcomed by the markets: global equities rocketed, and some have even begun to hear the fat lady singing, though this is far from certain.


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Making Lemonade out of Lemons – Market Liquidity

E. Silvia, Ph.D. Chief Economist, Wachovia

Yet the Fed is easing dramatically by using its balance sheet to provide more liquidity to the financial markets than would have been available via a cut in the funds rate. As suggested by our note last week, the interaction between quality heterogeneity and asymmetric information can lead to the disappearance of a market where guarantees are indefinite. In this model, as quality is indistinguishable beforehand by the buyer (due to the asymmetry of information). Because of the information/quality problems, we have watched the evolution toward a no-trade market where demand and supply never meet at any positive price. Markets fail to exist altogether in situations involving quality uncertainty. Into this breach steps the Fed and the Treasury to bridge the market gap. Through the back door, both institutions are providing the liquidity needed and altering the rules, actually they were more like guidelines, to do whatever is needed to buy time. Real solutions are yet to appear.

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The Battle Plan in “Lehmans” Terms

Steve Chan, Economist, TD Bank Financial Group

At its most basic level, the current problems resulted from two simultaneous innovations in the financial system. The first is the financial engineering revolution – of which mortgage securitization is but one example. Old finance said hold a stock or bond for a return relative to the risk. Now, derivatives allow for the ability to hedge risks associated with possible changes in interest rates, exchange rates, default rates – even the weather. This required the financial system to find ways to “financialize” more and more assets which weren’t commonly traded, like mortgages. The principle behind this was that financial players would have more liquidity and would be able to hold just the risks they felt comfortable with – no different than any individual investor rebalancing their portfolio to reflect their personal risk appetite. The second innovation was the expansion of risky lending – of which subprime mortgages was but one. For example, we have seen an increased holding of debts with lower credit rates relative to the past.

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Financial Markets: Forever Blowing Bubbles?

Trevor Williams, Chief Economist at Lloyds TSB Financial Markets

The bail out of Fannie Mae and Freddie Mac is '...one of the largest financial interventions not only in US history but in any country’s history. But the costs to the government is manageable' says an analyst at S&P. The liabilities of the two GSEs come to $5.4 trillion and will be added to the US government’s gross financial liabilities, though it will not impact its credit ratings say many (though costs associated with insuring against US government debt default - CDS spreads - reached some 20 basis points on the news, or $20,000 for every $10m of debt). Some $200bn has been set aside by the US authorities for potential losses on the assets of the agencies, but the cost is more likely to be $325bn according to S&P, some 2.3% of US gdp. This highlights the ever rising costs of the financial bubbles that have plagued the world economy in the last 10 years, in part related to US monetary policy in our view but also global monetary trends. So many financial firms have become ‘too big to fail’ one has to wonder where this process of adding private sector debt to the public sector will stop. What will ultimately prevent it, of course, is a situation in which the public sector also becomes unable to take on any more debt.

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