The sharp falls in many financial markets in late 2008 partly reflected forced position-closing by leveraged investors. Leverage levels now appear to be low by the standards of recent years, suggesting that future market moves will be driven more by “fundamentals”.

A measure of equity market leverage is margin debt outstanding on the New York Stock Exchange. This has fallen by 54% from a peak in July 2007, reaching its lowest level since August 2004 – see first chart below.

In the corporate bond market, deleveraging by market-makers with excessive inventory contributed to rapid price declines in late 2008. US primary dealers’ net long position in corporate securities is now the lowest since August 2003 – second chart.

Hedge fund leverage is difficult to measure directly but can be proxied by the sensitivity of their returns to market movements. The 30-day trailing betas of the FTSE "all strategies" and "directional equity" hedge fund indices to the FTSE World equity index are close to zero, suggesting little net market exposure – third chart.

As investors scrambled to close positions in late 2008, the Chicago Board Options Exchange implied volatility (VIX) index spiked to its highest level since the October 1987 stock market crash. Recent further equity declines were associated with a lower peak in volatility – fourth chart. A similar “non-confirmation” occurred at the October 2002 US stock market low, retested in March 2003.

Trade figures for January released today show little evidence of the economic benefits promised by the many advocates of exchange rate devaluation.

Contrary to the script, net exports appear to be exerting a drag on the economy in early 2009. Excluding oil and erratic items, export volumes in January were 8% below their fourth-quarter level versus a 5% decline in imports.

Meanwhile, manufactured import prices climbed a further 1% in January to stand 14% higher than a year before. Ongoing sterling weakness suggests the annual rate of change will remain in double-digits – see chart. As argued previously, the import price surge has lifted underlying inflation, thereby partly offsetting the boost to real incomes from lower energy prices and the VAT cut.

The weaker exchange rate may also have worsened the credit crunch by encouraging foreigners to reduce their sterling bank deposits and eroding banks’ capital ratios by inflating the sterling value of their foreign currency assets. Foreign net lending in sterling to UK-based banks fell by £63 billion between August and January. Credit constraints may have prevented some exporters from taking full advantage of the falling currency.

Sterling has weakened again following last week’s MPC decision to embark on “quantitative easing”. While this policy change is warranted, it carries inflationary risks from a possible further large fall in the exchange rate. These risks would have been reduced by smaller interest rate cuts, greater fiscal discipline and less “talking down” of the currency by policy-makers.

In January, the IMF predicted that the UK would suffer the largest GDP decline of the Group of Seven (G7) economies in 2009. This forecast looked suspect at the time – see here – and is not supported by recent data.

UK GDP peaked in the first quarter of last year and had fallen by 2.2% by the fourth quarter. Over the same period, however, GDP dropped by 3.0% in Italy, 3.1% in Germany and a whopping 4.8% in Japan. Canada was the best performer among the G7, with a decline of just 0.5%.

According to figures released today, UK industrial output fell by a further 2.6% in January to stand 11.4% below its level last February, when G7 industrial activity began to contract. Germany, France, Italy and Japan have all registered larger declines, however, while UK performance is only slightly worse than the US – see first chart.

Forward-looking indicators are also no weaker than the average. The second chart shows a measure of new orders derived from purchasing managers’ surveys of manufacturing and services. The UK indicator has risen for three consecutive months and is slightly above its US counterpart and significantly higher than the Eurozone measure, which is still falling. Meanwhile, stock market earnings revisions have been less negative than elsewhere recently – third chart.

Countries that tackle the shortage of money and credit will be the first to emerge from recession. The MPC should have embarked on “quantitative easing” last autumn, at the same time as the US Federal Reserve. It has at least acted before the European Central Bank and Bank of Japan, suggesting the UK is well-placed to recover earlier than the Eurozone and Japan.

The terms agreed by Lloyds / HBOS for its participation in the asset protection scheme appear to represent a good deal for the bank but the attraction for private shareholders is significantly reduced by their enforced dilution due to upfront payment to the Treasury in new B shares.

Combined lending of Lloyds and HBOS in the form of loans and advances to customers and holdings of trading and investment securities amounted to £935 billion at the end of 2008. The £250 billion of assets to be covered by the insurance scheme represents 27% of this sum.

Lloyds will suffer a first loss of 10% on the covered assets and a 10% share of additional losses, for which it will pay a fee equivalent to 6.25%. So the total cost of participation will be:

10 + 6.25 + 0.1 * (L – 10) %

where L = the ultimate percentage loss on the covered assets.

To justify participation, Lloyds must believe that this cost is less than L itself, i.e.:

L > 10 + 6.25 + 0.1 * (L – 10)

Rearranging terms and simplifying, participation is worthwhile if the ultimate loss L is greater than 16.9%.

Now assume that Lloyds has dumped all of its suspect assets into the scheme and that losses will be negligible on the remaining 73% of its lending. The 16.9% breakeven loss on the covered assets then translates into a 4.5% loss on its total lending.

As explained in a previous post, British banks in aggregate suffered five-year credit losses of 8.9% and 7.1% of assets at risk following the recessions of the early 1980s and early 1990s respectively. Assuming that 1) current losses are on the same scale or larger, 2) the combined loan book of Lloyds and HBOS is of no better than average quality and 3) Lloyds has succeeded in placing its lowest-quality assets in the scheme, the fee charged looks inexpensive.