Entries from October 1, 2007 - October 31, 2007
Glad to be glum part 2
Another favourite stomping ground of gloom-and-doom merchants is the dear old UK housing market. Remember those forecast house price crashes of 2005, 2003, 2001 etc.? Don’t worry – this time’s for real. Just look at the fall in mortgage approvals – down by 20% in 10 months; and the latest RICS survey showed a net balance of 20% estate agents expecting prices to drop.
Trouble is, mortgage approvals plunged by 43% in 2004, while the RICS expected prices balance reached -29%, and still prices didn’t fall.
Brian Durrant of The Daily Reckoning keeps arguing that the housing market will be the victim rather than the assassin of the economy. In other words, prices are unlikely to fall unless economic growth slows sufficiently to put upward pressure on unemployment. Leading indicators have yet to signal significant economic weakness and labour market conditions are currently solid.
Add to that a continuing lack of supply. Another good indicator from the RICS survey is the ratio of the current sales pace to the stock of homes on the market. As the chart shows, the ratio remains far above the low reached in 2005 and at a level historically consistent with modest price inflation.
I am not optimistic about medium-term prospects for UK house prices but the bears are getting overexcited.
Glad to be glum
Have you noticed how every piece of US economic news is being written up bearishly? Such one-way sentiment often signals an imminent reversal.
Take last week’s figures on new home sales, which – incidentally – are a better guide to current housing market conditions than existing home sales, because of a shorter reporting lag. New sales rose by 4.8 % in September while the stock of unsold homes fell again to a 20 -month low. Was that the message you got from your favourite economics correspondent? Of course not. I bet he / she talked about sales reaching an 11-year low in August, while opining that the September rise was a bounce of the dead feline variety.
Or consider yesterday’s consumer confidence number for October, which “slumped to a two-year low” and “raised the prospect of a marked deterioration in business conditions in sectors such as retail and consumer goods”. Call me senile but I have no recollection of the late 2005 consumer collapse. Take a look at the chart, which plots quarterly consumer spending growth with the confidence index. Does the recent move lower look like a “slump” to you? The relationship is not particularly close but it is a stretch to argue that spending is about to plunge .
GDP growth should slow in the fourth quarter but when expectations are this low it doesn’t take much to generate a positive surprise.
Markets counting on Fed Halloween "treat"
The release accompanying the Fed’s 50 b.p. rate cut on 18 September stated that the move was intended to forestall the adverse effects of tighter credit conditions. Credit markets have yet to normalise fully but are moving in the right direction. For example, the spread between the discount rates on three-month non-financial commercial paper and Treasury bills has fallen from over 100 b.p. at the time of the last Fed meeting to 60 b.p. currently. An earlier post argued that such a decline would support a forecast of contained economic weakness.
Economic news since the last meeting has been no worse than feared. August’s 4k decline in payroll employment, which provided convenient cover for the Fed’s 50 b.p. move, has since been revised to a gain of 89k, with a further rise of 110k reported for September. Third-quarter GDP figures tomorrow are expected to show annualised growth of about 3%, although a softer number is likely in the fourth quarter, reflecting higher energy costs as much as the “credit crunch”. Housing data have been weak but there are signs that activity is bottoming.
The Fed’s policy decisions have significant spill-over effects globally, particularly in emerging markets, where exchange rate links to the US dollar result in monetary conditions mirroring US developments. Policy-makers have been trying to restrain economic expansion in many emerging countries but their efforts were undermined by the Fed’s September cut. The emerging world boom is providing important support to the US economy in the form of strengthening export demand while putting upward pressure on headline (and possibly core) inflation as oil and other commodity prices continue to surge.
Current conditions may be contrasted with 1994 and 1997, when the Fed tightened monetary policy based on domestic considerations while emerging markets were in a weakened state, leading to the Mexican peso and Thai baht crises (December 1994 and July 1997 respectively). These crises fed back into slower US growth and downward pressure on inflation via falls in commodity prices, causing the Fed to reverse policy tightening in 1995 and 1998. The opposite feedback relationship currently implies that any further Fed easing will be limited and may be reversed in 2008.
As should be clear, I am unconvinced of the need for a further Fed move this week. However, officials have failed to intervene to check strong market expectations of another 25 b.p. cut so the default assumption must be that one will be delivered. This would strengthen the parallels between current conditions and 1999, when the Fed pumped liquidity into markets into year-end on concern about possible economic disruption from the Y2K changeover, to the delight of stock market speculators.
Rock loan: further big increase
"Other assets” on the Bank of England’s balance sheet rose by a further £4.7 billion in the week to Wednesday 24th October, bringing the total increase since the run on Northern Rock started to £20.6 billion. This is the best available estimate of the extent of the Bank’s support to the lender.
The weekly increase of £4.7 billion is up from £3.0 billion in the prior week and is the largest since the week to Wednesday 26th September.
The scale of the loan and its continued rapid increase suggest that, as well as losing wholesale funding, Northern Rock has suffered a larger withdrawal by retail customers than the guesses of several billion pounds circulating in the market (£5 billion plus?) This would also fit with the record level of savings receipts reported by building societies in September. (Building societies account for about 20% of all retail deposits and enjoyed an inflow of £2.8 billion last month, up from £1.0 billion in September 2006.)
Lessons of the liquidity freeze
The recent liquidity crisis was the first significant test of the Bank of England’s new framework for money market operations introduced in May 2006. The result must be judged a failure, not because of the enforced bail-out of Northern Rock, which may have been unavoidable, but rather because two of the stated objectives of the framework were not met: first, to achieve a flat money market yield curve consistent with the official Bank rate out to the next MPC decision date; secondly, to ensure efficient liquidity distribution even in stressed market conditions.
Of course, other central banks have also struggled to maintain functioning money markets, but the Bank’s critics argue that it has underperformed its peers in several respects. The first charge relates to the speed of its response. Market rates globally began to rise sharply on 9 August. The ECB conducted to an emergency operation to add short-term funds on the same day, with the Federal Reserve following on 10 August. On 17 August, the Fed reduced the penalty rate charged for borrowing from its discount window from one percentage point above the Fed funds target rate to 50 basis points, while extending the term of such borrowing. The ECB followed up on 22 August with a further special operation to supply three-month funds at an auction-determined interest rate. The Bank’s first action outside its normal operating framework was on 5 September, when it announced a possible short-term operation a week later if market conditions remained stressed. The actual supply of funds on 13 September occurred over a month after the crisis had broken.
The second criticism relates to the Bank’s insistence on charging a penalty rate of (at least) one percentage point above Bank rate on any lending outside its normal short-term repo operations. This condition applied to funds accessed via its discount window (the standing lending facility) as well as the operations to supply three-month funds announced on 19 September. As noted, the Fed reduced the penalty charged for discount window borrowing to 50 basis points, while the ECB conducted additional three-month operations at auction-determined rates (average rates in these auctions were 52 - 61 b.p. above the ECB’s official repo rate). The Bank’s hardline approach appears to be in contradiction to its own documentation on money market operations (the “Red Book”), which states that a cut in the standing lending facility rate relative to Bank rate is one of the Bank’s instruments for relieving stressed market conditions (paragraph 22 on page 8).
Thirdly, and perhaps most seriously, banks’ ability to access emergency funds from the Bank may have been constrained by much stricter collateral requirements than employed by the ECB and Fed. Under normal circumstances the Bank restricts eligible collateral to securities issued by the UK and other European governments and supranational bodies with a credit rating of Aa3 or higher. British banks hold few such securities. By contrast, the ECB allows private as well as public sector assets to be used, including mortgages, with a lower rating threshold of A. The Fed’s definition is similarly broad, though without a specified credit rating minimum. (The Bank loosened collateral requirements for the auctions to supply three-month funds announced on 19 September, but continues to use the stricter definition in its normal operations.)
The Bank’s defenders deflect such criticisms by arguing that alternative actions or procedures would probably have made little difference given the extent of dislocation in global markets. They claim that the lack of any intervention by the Bank until early September reflected distinctive features of the UK system, in particular banks’ ability to choose their target level of reserves balances at the Bank once a month, with the Bank then supplying these reserves at a non-penal rate. On this view, it made sense to delay additional action until the start of the new reserves maintenance period on 6 September, when banks would be able to access additional funds.
In reality, market dislocation was never likely to be relieved simply by banks requesting higher reserves targets. Once targets are set, banks are required to maintain actual reserves within 1% of the specified amount on average over the maintenance period; deviations incur penalties. In other words, the additional reserves supplied on 6 September did not meet banks’ demand for a cushion to meet unforeseen liquidity demands. This was provided only on 13 September, when the Bank widened the permitted deviation of reserves from targets to 37.5%. Such action could have been taken much earlier and indeed is mentioned as a second instrument for relieving stressed conditions in the “Red Book”.
Another claim is that the more timely actions of the ECB and Fed had little effect. It is true that term premiums in money market rates in the Eurozone and US remained unusually high, but they were consistently lower than those in the UK over the month to mid September.
Finally, the fall in term rates in recent weeks, including relative to Eurozone and US rates, is cited as evidence that the Bank has regained control of markets. Some commentators even suggest that banks’ unwillingness to bid for funds at the three-month auctions supports the Bank’s earlier inaction. Such claims neglect the liquidity impact of the Bank’s enforced lending to Northern Rock, which succeeded where its operational actions had failed in breaking the logjam in markets. Term rates began to decline significantly on 14 September – the day the Bank announced its lender-of-last-resort support. In effect, Northern Rock’s shareholders paid the penalty rate demanded by the Bank to supply the banking system as a whole with greater liquidity. Without Northern Rock, market rates would almost certainly have been higher and banks would probably have borrowed funds in the three-month operations.
At a minimum, the Bank faces charges of tardiness and a failure to use the full range of instruments available for relieving stressed market conditions according to its own “Red Book” framework. However, changes to the framework itself also appear to be necessary in light of recent events, in particular a widening of the definition of eligible collateral and the addition of term auctions as an instrument for maintaining functioning markets.
Earnings revisions still consistent with "soft" landing
IBES figures on changes to equity analysts’ earnings forecasts in October are now available. A useful summary measure is the world “revisions ratio” – upgrades minus downgrades divided by the total number of estimates. The ratio moved further into negative territory, reaching its lowest level since 2003. More grist for the bears?
Perhaps not. The revisions ratio exhibits a seasonal pattern, with a clear tendency for analysts to become less optimistic (more realistic?) on their return from summer holidays. As the chart shows, after adjusting for seasonal factors the ratio is still at a level consistent with moderate G7 industrial growth.
Two further points are worth noting. First, the regional breakdown shows more downgrades in the Eurozone than the US in October (after adjusting for seasonals). This fits with my view that the consensus is too fixated with US economic weakness and is underplaying downside risks in Euroland.
Secondly, the measure shown in the chart excludes emerging markets, for which analysts are still marking up earnings estimates. Solid emerging world growth remains an important offset to economic weakness elsewhere.