naked capitalism

The warning from the ECB’s chief Jean-Claude Trichet. that the worst of the credit crunch may lie ahead, deserves to be taken far more seriously than other cautionary warnings. First, he has a reasonably good reading on what is happening with European banks (and our sources with inside connections have maintained for some time that they are in worse shape than is generally acknowledged). Second, he talks to other central bankers. Third, and most important, someone in his position usually understates looming problems so as not to get the public unduly alarmed.

Even with this concerned outlook, Trichet, in stark contrast to Bernanke, is not willing to risk stoking inflation via overly aggressive rate cuts. From the Telegraph:

Jean-Claude Trichet, the head of the European Central Bank, has indicated that the worst of the credit crisis may not be behind us.

Mr Trichet said that we were seeing “an ongoing, very significant market correction.”

He compared the recent hikes in energy and food prices to the oil crisis of the 1970s, when higher wages undermined Europe’s ability to compete, resulting in widespread unemployment.

He warned that despite the economic slowdown, central banks should not be tempted to cut interest rates because that could lead to more serious problems.

While the Bank of England and the US Federal Reserve have made a series of interest rate cuts since the crisis in the financial markets began, the ECB has held interest rates at 4pc in response to inflation.

In an interview with the BBC today, Mr Trichet implied that the ECB was unlikely to cut interest rates in the short term.

He said however that high inflation “will not last forever.”

Trichet’s views are echoed by Willem Sels, head of credit strategy at Dresdner Kleinwort, quoted in today’s Financial Times:

….while liquidity tensions are easing, the market is entering a second phase of the crisis. Real credit losses are accelerating and many areas of the market have yet to see the worst of the crunch. He says corporate defaults have only just started rising and he expects high yield defaults to accelerate sharply to 7-11% by mid-2009, particularly in the US.

The market, however, is only currently pricing in a 6% rate of default, he estimates. Mr Sels says rising corporate and consumer defaults will lead to real losses in portfolios, leading credit spreads wider, especially for non-financials.

He notes the weakness in the housing market seems to be gathering momentum and could still provide a shock to the economy.

“Even if we get a W-shaped economic recovery, the current mid-cycle credit rally seems overdone,” says Mr Sels. “We believe the recent rally has been exacerbated by investors who are “afraid to miss out” or who are too impatient to recognise the lags with which the economy and the profit cycle typically react to shocks.”

Bank risk appetite will remain low and lending will therefore remain depressed, leading to a long period of sub-trend GDP growth and weakening corporate profit margins.