The assessment here a month ago was that Chinese monetary policy easing was gaining traction but that additional stimulus and a further recovery in narrow money momentum were required to adopt a positive view of economic prospects.

These conditions have been partially fulfilled: the PBoC has delivered additional easing and six-month narrow money growth picked up in July; however, a food-driven rise in CPI momentum held back real money expansion.

The news, on balance, warrants an upgrade to the assessment: economic momentum is judged likely to recover in late 2022 / H1 2023 barring further negative shocks.

This interpretation, of course, is at odds with deepening consensus gloom. According to the consensus, this week’s “surprise” rate cut was a panic response to worryingly weak July activity and credit data.

The PBoC, like other central banks, controls short-term money market rates by adjusting the supply of bank reserves relative to demand*. Money rates have fallen steeply since late July, signalling that the PBoC was stepping up easing – see chart 1. Rather than a panic move, the cut in official rates confirms a policy shift that began weeks ago.

Chart 1

Weaker-than-expected July activity numbers probably reflect payback for May / June gains boosted by catch-up effects following covid disruption. Seasonally-adjusted levels of key series remained comfortably above April lows – chart 2.

Chart 2

Talk of credit weakness is also exaggerated. The small rise in broad credit (total social financing) in July follows a larger-than-expected increase in June, with six-month growth the same as in April / May – chart 3.

Chart 3

The consensus view ignores better monetary data. Six-month broad money growth in July was stable at the highest level since August 2020. Narrow money growth rose further to its highest since January 2021.

The disappointment in July data, from the perspective here, was a pick-up in six-month CPI momentum, which dragged real money growth lower despite the nominal acceleration – chart 4.

Chart 4

CPI strength was driven by food (pork) prices with annual core inflation still low (0.8%) and PPI inflation falling. Earlier monetary weakness argues for a benign near-term inflation outlook and base effects suggest a decline in six-month CPI momentum in September / October.

*The supply of reserves reflects factors such as flows into / out of government accounts at the central bank and foreign exchange intervention as well as open market operations, changes in reserve requirements etc. Estimates of net supply based only on observable OMOs and other interventions are liable to be misleading whereas movements in money rates reflect the balance of all supply / demand influences.

The yield spread over Treasuries of the ICE BofA US corporate high yield index rose from 310 bp at end-December to a peak of 599 in early July. It has since retraced more than half of this move. Was the early July peak a major top, with a further decline in prospect? This seems unlikely, for several reasons.

First, the “financing gap” of non-financial corporations – the difference between capital spending and domestic retained earnings – is a long leading indicator of credit spreads and has widened significantly in recent quarters.

Chart1 shows an expanded measure of the gap including financing required for net equity purchases. This measure moved from a negative position (i.e. a surplus) in Q1 2021 to 4.3% of GDP in Q1 this year, reflecting a strong rise in capital spending – including on inventories – and a pick-up in equity buying.

Chart 1

The expanded financing gap rose above 4% of GDP in 1989, 1998, 2000, 2006 and 2019. The high yield spread subsequently increased to at least 850 bp. (The gap also exceeded 4% in Q4 2017 but was temporarily inflated that quarter by revenue shifting by corporations to take advantage of lower tax rates from 2018 – there was an offsetting surplus in Q1 2018.)

Secondly, the high yield spread correlates contemporaneously with the credit tightening balance in the Fed’s senior loan officer survey – chart 2. This rose sharply between April and July and special questions in the July survey suggest a further increase in H2 – see previous post for more details.

Chart 2

Thirdly, the stockbuilding cycle is judged here to have entered a downswing that may – based on the average length of the cycle – extend into mid to late 2023. Historically, the high yield spread has usually peaked late in the downswing or even after the trough – chart 3. The 2011-12 downswing was an exception but the early surge in the spread on that occasion probably reflected credit market contagion from the Eurozone sovereign debt crisis.

Chart 3

Finally, the two measures of global “excess” money tracked here remain negative, a condition historically associated with a widening spread on average – table 1. The first measure – the gap between six-month real narrow money and industrial output momentum – may turn positive during H2 but the second measure – the deviation of 12-month real momentum from a moving average – will almost certainly remain negative. That combination has also been negative for credit historically.

Table 1

The Fed’s July senior loan officer survey signals a major slowdown in US bank lending in H2 and 2023.

Most commentary focuses on survey responses about credit standards and demand for commercial and industrial (C&I) loans. However, the Fed calculates aggregate indicators incorporating data for all loan categories (i.e. also including commercial real estate (CRE), consumer and residential mortgages).

These indicators weakened sharply in Q2*, moving below their averages since 1995 – see chart 1.

Chart 1

Demand for residential mortgages weakened most, with smaller declines for CRE and consumer loans. C&I loan demand remained strong, driven by inventory financing (negative for economic prospects).

Credit tightening was across the board but most pronounced for CRE and C&I loans. Banks cited a less favourable economic outlook, industry-specific problems and reduced risk tolerance as key drivers of the tightening of C&I loan standards.

Is the degree of credit restriction consistent with a recession? The Fed’s aggregate credit tightening indicator combines data for the various loan categories using their weights in banks’ lending books. The indicator is unavailable before 1995 but similar results are obtained using a simple rather than weighted average, and this alternative indicator can be estimated for earlier years from partial data for the loan categories.

Chart 2 shows that this alternative indicator rose above 28% before or during seven of the last eight recessions, with no false positive signals. The single false negative was the double-dip recession of 1981-82, which was arguably an extension of the 1980 contraction rather than a separate cyclical event.

Chart 2

The indicator rose from -4% in the April survey to 17% in July, i.e. below the critical value. The current level was reached in 1968, 1978 and 1998 without an accompanying recession.

The July survey, however, included special questions about banks’ expectations for credit tightening for selected loan categories in H2. A net 52% expect to tighten standards on C&I loans, up from an actual 23% in Q2. Smaller but significant increases are signalled for consumer loans and residential mortgages. Assuming no change for CRE loans (which were not covered by the special questions), the aggregate alternative indicator in chart 2 is forecast to rise to 33%, i.e. above the 28% recession threshold.

*The survey cut-off date was 30 June.