The prolonged disconnect between the debt and equity markets is bizarre. Historically, credit market corrections precede equity downturns; once in a while, as in 1997-1998, they send a false positive, so equity investors feel justified in not taking every blip in the credit markets to heart. (And we aren’t the only ones to think along these lines, witness this post by Michael Panzner).
But although there is a good deal of variability, in the stone ages, the typical lag between a tighter credit and an equity decline was four months, and the tendency has been for it to shorten. If you put the beginning of the credit downturn at June 7, when ten year Treasury bond yields jumped upwards, breaking a long-established historical pattern that traders saw as a sign of the long decline in interest rates, the equity markets still have some time before a correction looks overdue.
Of course, the reason for the cheer in stock-land is that the Fed rode in to the rescue on September 18 with its 50 basis point cut in the Fed funds rate. But did that work as well as the bulls would have us believe?
We noted Friday that the commericial paper markets were still rocky, and the Financial Times reported Saturday the credit markets look weak:
Markets and the world economy are in a no-man’s-land 11 days after the US Federal Reserve’s dramatic half-point interest rate cut….conditions in the interbank money market and other troubled corners of the financial system remain far from normal….
If the US economy does deteriorate severely from here, sickly credit markets would have to absorb another shock: this time from rising expected defaults on a wide range of US assets. That could put the market healing process into reverse.
Even before Friday’s distress sale of Net Bank, a US internet bank, Fed officials were wary of assuming that the crisis is past.
Fed policymakers do see a welcome change in tone and sentiment since their rate cut, with investors starting to differentiate much more between assets and investment vehicles.
The effects of this have been most marked in the asset-backed commercial paper market (ABCP), where stress is now more tightly confined to paper backed by problem mortgages and special investment vehicles (SIVs) that are not backed by strong banks. Credit spreads have also narrowed.
The market for leveraged buy-outs is starting to re-open and spreads between agency conforming and non-conforming mortgages have tightened a little.
But Fed officials still believe markets are fragile. They are a little concerned by the slow progress in the non-conforming mortgage market.
While interbank lending spreads as well as rates fell in the aftermath of the rate cut – much to the relief of Fed policymakers – spreads have moved up again.
“There is still a clear dislocation in money markets and the new high in Euribor is a genuine worry,” said Dominic Konstam, head of interest rate strategy at Credit Suisse. “Volumes in the market are running at 10 per cent of normal activity.”
Officials blame the latest uptick in interbank spreads on quarter-end and year-end husbanding of liquidity. They see that big banks are still hoarding cash owing to uncertainty about how many assets currently held in investment vehicles will come back on balance sheet.
With mostly smaller and weaker banks seeking to borrow, interbank lending rates have been pushed up by so-called “adverse selection”.
Policymakers do not expect markets to recover rapidly, in part because of the overhang of securities. Weak SIVs unable to obtain financing may have to liquidate their portfolios, while banks still have a huge portfolio of leveraged loans to distribute.
Most investors still lack valuation models capable of evaluating the most complex credit products.
The Fed rate cut “does not cure the ills of the liquidity crisis”, said Jim Caron, co-head of global interest rate strategy at Morgan Stanley. Many institutions have had to rely on shorter-term funding in recent weeks, making them vulnerable to bad news….
It is possible for improvement in market functioning to co-exist with increasing concern about the economy – but not for long. Either the economic data will point upwards, in which case the market healing process should speed up, or they will point downwards and then markets are likely to take another turn for the worse.
Dennis J Snower at VoxEU reaches a similar conclusion via a different route. He believes a mere continuation of the credit crunch will hurt growth. Worse, given that the pullback was the result of overvalued US housing, and many other economies have real estate that is even more overpriced than ours was, he is worried about the possibility of housing contagion.
For years economists and policy makers have worried about the fragility of the US economy, and particularly about the un-sustainability of the US housing boom, but when the shock finally occurred, everyone – central banks, commercial banks, hedge funds, private investors – appears to have been unprepared. The big surprise was the nature of the shock. Suddenly banks stopped lending to one another, except on punitive terms. Liquidity dried up, threatening the existence of otherwise well-functioning banks and businesses. The crisis of confidence jumped across US borders with ease, as the recent run on Northern Rock has shown. How will this financial turbulence affect the world economy?….This is my purpose – not to make a forecast, but to warn of possible dangers ahead.
Investors tend to imagine that the world will continue to be approximately like it is now. Before the US Federal Reserve reduced the benchmark interest rate by one-half percentage point on Tuesday, September 18, financial markets were in despair; afterwards they were euphoric. Such myopia is dangerous. So far, economic activity – production, employment, consumption, investment and trade – have remained largely unaffected by the credit crunch. Many seem to believe this will continue. Equally dangerous.
If the credit crunch persists, there can be no doubt that economic activity will suffer. The Fed’s interest rate cut will not prevent US home foreclosures, nor will it eliminate the glut of unsold homes. If US house prices continue to fall and unemployment continues to rise, consumers will doubtlessly reduce their spending, and the fall in demand will aggravate the rise in unemployment, hurt the US stock market, and thus lead to a further fall in spending.
Meanwhile, it is worth keeping in mind that the US is not the only country where house prices have risen much faster, on average, than national incomes. On the contrary, house prices in Australia, Britain, Denmark, France, Ireland, Spain, and Sweden have all increased faster, over the past ten years, than in the US. Of course the US is a special case on account of its subprime mortgage lending towards the end of its housing boom. There, mortgage lenders with poor credit records could buy houses at virtually interest-free for a few years, before the rates were adjusted steeply upwards. But the danger of international contagion remains. The US housing slump may well lead investors in Europe to reassess the value of their properties. If that happens, then consumption spending is likely to fall in the countries listed above, leading to weaker labour markets.
This could happen at a time when the Chinese economy has overheated and will need to slow down, and when the Japanese economy is stagnating. There are no other countries to take-up the slack, to serve as a “motor” for the world economy, as the US has done for so long.