The co-ordinated liquidity operation announced by central banks yesterday is promising but questions remain about its implementation. The market response has been muted: three-month dollar LIBOR was fixed just 7 bp lower this morning, while the corresponding euro rate was unchanged.

The Fed’s new “term auction facility” is modelled on the ECB’s three-month repo operations, although the first two auctions will be of shorter maturity (28 and 35 days). The key features are 1) a non-penal, market-determined interest rate, 2) acceptance of a broad range of collateral and 3) borrower anonymity.

However, the ECB’s auctions have not been reflected in greater success in reducing Eurozone LIBOR premiums compared with those in the US and UK. The reason is simple: the ECB has offset its additional three-month lending by cutting back funds supplied in shorter-term operations. Banks' reserves at the ECB have shown little change since the onset of the liquidity crisis.

The success of the new operations therefore depends on them being used to increase aggregate central bank lending to the banking system, not just extend the maturity of existing support. The outcome will be unclear until after the auctions take place, partly explaining the market’s muted response.

One curious feature of the operation is that the ECB will offer dollars to European banks but is not planning additional euro lending. This explains the failure of euro LIBOR rates to match the modest declines in dollar and sterling rates.

Back in October I suggested US housing market pessimism was overdone and activity was probably bottoming. The jury is still out but home sales edged higher in September and October – see first chart. One hopeful sign was an improvement in the home-buying conditions index from the University of Michigan consumer survey. As the chart shows, this indicator rose further to a seven-month high in early December.

Weekly mortgage applications for house purchase have recovered to their highest level since January  – see second chart. There are well-known problems with this series – it is biased towards prime borrowers and may be distorted by people making multiple applications – but the recent upward trend is encouraging.

The collapse in home sales from mid 2005 was preceded by a sharp drop in the housing affordability index calculated by the National Association of Realtors. This index bottomed in mid 2006 and has recovered significantly since the summer, reflecting lower home prices and a large decline in mortgage rates for prime borrowers – see third chart.

Construction indicators have yet to show improvement but the NAHB homebuilders index stabilised in November – December's survey is released next week. While still high, inventories of unsold new homes have been falling for over a year, reaching a 22-month low in October. Homebuilders’ stock prices tend to lead housing starts and may be in the process of forming a bottom. As the final chart shows, a recent rally in the S&P homebuilding index broke the downtrend in place since the summer and prices are now retesting the trend line from above. It would be encouraging if the index finds support at the line; a renewed fall below would signal new lows ahead.

Numerous commentators – including Bank of England Governor Mervyn King – have expressed surprise at the resilience of equity markets given the significant risk of a global “hard” landing. My attempt at an explanation goes as follows.

As I have noted before, G7 industrial output growth peaked at an annual 4.5% in September 2006, marking the start of the current economic downswing. 12 prior downswings in G7 industrial growth can be identified over the last 40 years. Six were associated with US recessions, as defined by the National Bureau of Economic Research – “hard” landings. The remaining six can be termed “soft”.

Unsurprisingly, global equity markets tend to perform well in soft landings and badly in hard landings. I calculated an index of average performance starting from the cyclical peak in G7 industrial growth for each of the two groups. I then superimposed these averages on the current cycle – see chart.

Global equities have so far followed the historical soft landing path closely. Does this imply that markets are irrationally ignoring the significant risk of a hard landing? Not necessarily. If the current downswing does indeed turn out to be soft, the historical average would suggest a further rise in equities of 20% from closing November levels by the end of 2008. If a hard landing transpires, a fall of 13% is indicated. The resilience of equities may therefore partly reflect market participants’ assessment that the potential gain in a favourable economic scenario exceeds the loss in the event of a US recession / hard landing.

Based on recent economic evidence, it seems reasonable to assign 60% / 40% probabilities to soft / hard landings at present. Using the historical averages shown in the chart, this would imply a probability-weighted price change between November’s close and the end of 2008 of +7% (i.e., 0.6*20 - 0.4*13). Adding on dividends gives an expected return of 9%. This compares favourably with cash rates and likely bond performance.

Equity markets will clearly weaken if the probability of a hard landing increases further but current price levels are defensible based on the latest economic indicators.