I watched the Lamb open the first of the seven seals. Then I heard one of four living creatures say in a voice like thunder “come and see!” I looked, and there before me was a white horse! Its rider held a bow, and he was given a crown, and he rode out as a conqueror bent on conquest. Revelations 6:1-2
The exception of these growth-recessions, where the economies grow at less than productive potential, will be Western, Central and Eastern Europe, where we believe that there is little prospect of the sovereign debt crisis being resolved this year, but equally we do not believe that politicians will cause the single currency to break up. The result will be deflationary and given the shortage of safe haven currencies and associated triple AAA sovereign credit ratings suggests that forward government bond rates will be significantly lower by the end of the third quarter with 10yr spot rates below 1% and 5y5y forward rates in treasuries, bunds and gilts below 2%. Nevertheless, we believe that further quantitative easing from the Bank of England and the Fed as well as massive expansion of the ECB balance sheet through additional liquidity provision will help reduce systemic risk in the financial system by reducing the likelihood of banking accidents as well as preventing destabilising debt deflation.
However, there are clear risks to our forecasts. In the spirit of equality the first risk to focus on is the bond bear trap that we are witnessing a repeat of 1994, when treasuries rallied in the first half of January. Loath as we are to mention spot rates, in the absence of applicable forward rates, we can see from the chart that 10yr treasury yields dropped from 5.92% at the start of the year to a low of 5.57% on January 12th.
This proved to be the mother of all head fakes and while the pre-independent Bank of England reduced base rates by 25bps in early February the bullish bond market sentiment was quickly reversed by Fed’s first tightening move in late February. The period from 1988-1994 is the most directly applicable to the current financial crisis, representing the herald wave of the global financial crisis. The eighties housing boom in the US was led by the savings and loans (America’s mutual building societies), who expanded rapidly during the period through leverage. The Fed’s tightening in 1987-89 produced the inevitable collapse of the sector.
The savings and loans industry represented around 15% of a much smaller financial system and the authorities followed the correct procedure by setting up the Resolution Trust Corporation to rapidly shut down insolvent financial institutions and prevent zombie financial institutions from clogging the financial transmission mechanism. Nevertheless, this relatively minor early warning signal (house prices did not contract during this period, lulling the investment bank finance models into a false sense of security over sub-prime mortgages), contributed to the mild 1990-91 recession but helped determine the subsequent jobless recovery as money supply and the velocity of circulation slowed sharply, broad M3 growth turned negative in February 1992 as credit was constrained and banks were unwilling to lend. These two trends are evident in the two charts below, which show the percentage of banks tightening lending criteria for commercial and industrial loans, the benchmark measure of corporate credit, and M3 broad money supply growth.
The impact of this mini-crunch can be seen on the unemployment rate and the Fed funds rate where the central bank reduced the funds rate from 9.75% in 1989 to a low of 3% in November 1992 and held this rate steady at this low level for fourteen months before doubling the rate over the following twelve months. The catalyst for this rapid tightening was the improvement in bank balance sheets. After four year of impairment, banks were able to rapidly expand their balance sheets. This was evident in the steepening of the yield curve in the wake of the first hike through until the middle of April as banks rapidly sold down their treasury holdings to fund increased consumer and business lending.
The key is whether US banks and other financial organisations have returned to balance sheet health and are willing to increase lending and more importantly consumers are willing to increase substantially their leverage. If they are then the Fed has a serious problem because the task of cooling the economy will make the 1994 episode seem like a drop in the ocean. The Boston Consulting Group estimates that if the velocity of circulation of base money, which is currently 5.7x, were to accelerate back to the 17.7x rate that prevailed in 2007, then the consumer price level would increase by 296% and the Fed would be forced to reduce its balance sheet by $1.8tr.
The BCG estimate represents an extreme example and has no credibility in reality because the Fed would be forced to step in long before velocity rose back to 2007 levels, while corporate and consumers’ liquidity preference is likely to remain elevated for many years. Indeed, the sheer extremity of the estimate identifies why central banks cannot afford to pursue endless quantitative easing and why they will always pause after a prolonged bout of unconventional monetary stimulus to gauge whether it is working. There have been some tentative signs of improvement in US bank lending over the past five months and household debt to GDP has fallen over the past three years, but while positive lending is an obvious improvement, the scale is limited, whilst most of the decline in household debt to GDP ratio has been driven by foreclosures and bankruptcy rather than increased savings and consumers paying back debt. Indeed, the household savings ratio fell sharply during the second half of 2011, from 5.0% in June to 3.5% in November.
The weakness in chain store sales at the start of January is consistent with our view that this lower savings ratio is unsustainable. 3.5% savings ratio is below the average prevailing since 2000, yet employment, labour force participation, house prices and net wealth as well as real wages are all considerably lower than their median rates over the past twelve years. Indeed, we expect the saving rate to rise back towards 5% during the second quarter, causing growth to slow sharply and the recent decline in unemployment to reverse by the middle of the year. This will push the threat of 1994 even further into the tail risk and bring additional Fed quantitative easing. We believe that the risk that banks will party like its 1994 is less than 10%. As Carmen Rinehart and Kenneth Rogoff identified in their seminal work “Eight Centuries of Financial Innovation – This Time it is Different” found that after a major financial crisis, the deleveraging process took several years to restore balance sheet health. Given the iniquitousness of the credit crunch across the major industrialised economies, we believe that it will take at least a decade to restore the health of financial, consumer and government balance sheets. To assume otherwise, is to believe in the conquest of ban
Chief Economist, Co-Fund Manager
Jan 30, 2012 at 3:53pm