The Mini Ice Age AND the Dust Bowl?Posted: October 26, 2008 Filed under: U.S. Economy | Tags: credit market thaw, economy, Equity Markets, financial meltdown, recession 2 Comments
I thought I’d try to give you some information on the mixed signals coming from the markets. First, we have the credit markets where people borrow and lend things like commercial paper, loans, and bonds. All of the money thrown into this market by the world’s governments appear to be having some impact.
How do we know this? As reported by The Economist, we see signs that banks are lending to each other and that interbank lending rates are behaving more normally.
An important indicator of its health is the price that banks say they expect to pay to borrow money for three months, which is usually expressed as the London Interbank Offered Rate (LIBOR), or its European equivalent, EURIBOR. These have been ticking down slowly, often by only fractions of a percentage point a day. Yet on Tuesday October 21st the rate for borrowing euros passed an important milestone, falling to 4.96%, a level last seen before Lehman Brothers collapsed in mid-September. The LIBOR spread over three-month American Treasury bills has also narrowed sharply. The recent improvements were partly stirred by the latest lavish intervention from the Federal Reserve. It made available $540 billion to buy assets from money-market funds, to encourage them to start buying commercial paper issued by banks and companies again.
A few words of explanation here. First, the Libor Spread over three-month Treasury bills is called the Ted Spread. Since the three month treasury bills are considered extremely safe, this spread is considered a measure of risk as perceived by the market. The bigger it is, the more likely banks are to see risk or some kind of uncertainty in the market. When you have a so called flight to quality, folks and institutions buy a lot of three month treasury bills and drive the yields down. This makes the spread widen. The Libor and the Eurobor are like the Fed Funds rate. These rates are established by the market for lending between banks. Banks that require more liquidity to cover things like withdrawals, loan losses, or reserve requirements for a very short period of time will borrow from other banks rather than go to the FED or their central bank. It is a market that shows how needy banks are for cash. Like all things related to supply and demand, when supply is short and demand is high, the loan rate goes up.
When the banks book the loans, and report the loans to their regulator, the regulator sees this market established rate and based on if it wants banks lending or holding on to money, will set its own rate. This is called the Discount Rate in the U.S. It is the loans you get from the Fed which is the lender of last resort. Remember, as of this spring, all financial institutions (FI), not just member banks, can access the discount window. Also, when borrowing at the discount window, the FI is required to put up some collateral. Many things are now being accepted as collateral–including toxic assets.
If this rate and the spread are ‘ticking down’ that means more and more demand is driving the rates down. The only reason that banks would increase their demand for these funds would be to lend at higher rates. This lets us know that the credit markets are slowly unthawing. We can see this further, as The Economist reports, in the market for interbank lending. Loans are being made between banks.
American banks including JPMorgan Chase and Citigroup have, in the past week, made loans to European counterparts for up to three months. And HSBC, Europe’s biggest bank, says it is providing billions in three- and six-month funding to banks.
This is a very good sign for the credit markets.
So, why are the equity markets still volatile and the major indexes falling? Equity Markets respond to more ‘REAL’ phenomenon because the earnings of companies are based on projects that either yield income or losses. The stock markets which sell pieces of companies and their future earnings are reacting to economic news. The economic news is looking pretty dismal right now.
Last week, the UK announced that it was in a recession. Most economists (including me) think we have entered a recession now in the U.S. This is spilling over to the global economies that rely on exports (like China, India, and any of the oil-exporting countries) because if they’re not selling to their customers, their companies are not making any income. No income on projects means stock values fall.
The global credit crunch is quickly turning into an economic crisis. At least, that’s what the markets feel. Stock markets all over the world and markets for foreign currency are sinking. The pound is doing miserably. The Eurodollar is one of the better-off currencies. The dollar is showing some recovery which is a bit odd given we’re considered the source of all this mess. However, we are the world’s currency and considered a safe-haven, so it might just be that old fashioned flight to quality again. I have to say, it’s very hard to tell at this point. It looks like the world still likes us to me. But this is just my analysis.
So the fundamentals here in the U.S. economy are pointing to a recession that will look more like the one in the 1980s than the last two short downturns experienced in the 1991 and 2001. This from today’s New York Times:
When October’s job losses are announced on Nov. 7, three days after the presidential election, many economists expect the number to exceed 200,000. The current unemployment rate of 6.1 percent is likely to rise, perhaps significantly.
“My view is that it will be near 8 or 8.5 percent by the end of next year,” said Nigel Gault, chief domestic economist at Global Insight, offering a forecast others share. That would be the highest unemployment rate since the deep recession of the early 1980s.
Companies are laying off workers to cut production as consumers, struggling with their own finances, scale back spending. Employers had tried for months to cut expenses through hiring freezes and by cutting back hours. That has turned out not to be enough, and with earnings down sharply in the third quarter, corporate America has turned to layoffs.
This and the fall in housing prices as well as bank failures have lead people to wonder about another Great Depression. For the answer to this, I point you to an Economic View that also came from the New York Times by well-respected Economist Gregory Mankiw. He points out to some very important reasons why this may be a bad recession but is unlikely to become another Great Depression. Here’s perhaps his most cogent argument on why this is unlikely to happen.
Probably the most important source of recovery after 1933 was monetary expansion, eased by President Franklin D. Roosevelt’s decision to abandon the gold standard and devalue the dollar. From 1933 to 1937, the money supply rose, stopping the deflation. Production in the economy grew about 10 percent a year, three times its normal rate.
We are no longer constrained by a fixed money supply and we have a Fed that knows a lot more about what causes crises. (Mankiw is a fairly conservative economist so this is a telling comment.) Widespread deflation (decreases in prices) were a problem during the depression years. The only major deflation we’ve had to date is in house prices. We’re now experiencing decreases in oil prices but unlikely to see declines in other items, like food and clothing. Oil prices were considered way higher than the fundamentals would suggest so this decrease is likely to help the economy. It is possible that air fares could come down, for one.
Also, I’ll point to the information reviewed in The Economist, loans were nearly impossible to get during the Great Depression. The world’s Central Banks are taking huge steps to ensure this doesn’t happen, and it appears their steps are working. Oddly enough, sales of existing homes went positive last month. It’s hardly a trend, but it does show a possible break in the downturn.
So what exactly do we see here? There are plenty of signs that we’re in for a fairly sustained recession through next year. Again, hold on to your job if you have one. Markets are trying to find their bottom. The Dow Jones is hovering around 8200 which is considered a threshhold level. There is some volatility but nowhere near the volatility we saw during the Great Depression. Credit Markets are thawing which means monetary policy may have a chance at jump starting the real economy again. The mini-rally in the dollar shows that the world still has a lot of faith in the fundamentals of the U.S. economy. We’re still considered that quality that attracts money. Don’t pull money out of anything long term. You’ll probably be selling it at a low. Try not to look at your 401k statements for awhile. Look for bargains if you do have money– vacations, cars, houses, and anything else that you’ve intended to buy but only if you know your job is safe and you have a nice emergency fund. If you don’t have an emergency fund ( about six months worth of income in a bank account), start one today.