Global financial conditions have improved significantly in recent months, following unprecedented policy action and signs of demand and output recovery. In turn, the decline in risk premiums and increased credit availability are helping consolidate the economic recovery, though pressures from unemployment and corporate default still weigh on its sustainability.
Risk Premiums Have Subsided from Historic Highs
Rising confidence in corporate earnings and emerging market securities has increased risk appetites, cutting the extra yield investors demanded to hold these assets.
- Bloomberg's Financial Conditions Index, which monitors the level of stress in the U.S. financial markets, was less than 0.5 standard deviations below normal levels this week, after reaching 11.5 standard deviations at the depth of the crisis last autumn.
- Emerging market sovereign bond spreads narrowed to 299 basis points, each of which is .01 percent, this week, down more than 550 basis points from their peak a year ago. Spreads, the difference between the yield of a particular asset and that of a “zero-risk” U.S. treasury, gauge the risk that investors perceive in holding the asset; smaller spreads imply lower perceived risk.
- Asian corporate spreads narrowed to 360 basis points, the lowest since July 2008, down from a record 953 basis points in October 2008.
- Investment-grade (or high quality) corporate bond spreads fell to 253 basis points in the United States and 205 basis points in Europe on August 31, down from 548 and 422, respectively, last April, with the U.S. spread lower than the 344 basis points level it reached last September, before the failure of Lehman Brothers.
- Spreads for U.S. high-yield (or riskier) corporate bonds have narrowed to 826 basis points, down by about 1000 basis points in the five months to August.
Credit Availability is Increasing
As worries of systemic collapse and economic free-fall have abated, banks have become more willing to lend, liquidity has increased, and market volatility has declined, indicating some return to normalcy in the credit market.
- The Libor-OIS spread, the difference between the London Interbank Offered Rate (LIBOR) and the overnight index swap (OIS) rate, narrowed to 16 basis points, down from 176 in September 2008 and now very close to its typical pre-crisis level. A lower spread generally signals a heightened willingness among banks to lend to each other.
- The TED spread, the spread between the 3-month Treasury Bill rate and the 3- month LIBOR rate, fell to 23 basis points this week after peaking at over 450 basis points last October.
- According to National Association of Credit Management (NACM), the U.S. Credit Managers Index (CMI) reached an 11-month peak of 49.8 in September, up from 48.1 in August (with readings above 50 signaling growth).
- According to the Bank of England, overall credit availability to the corporate sector increased 24.8 percent in the three months to September from the previous three months.
The reduction of systemic risks, along with an improved economic outlook, has raised demand for riskier assets as corporate profits have grown.
- The MSCI world and emerging markets equity indices have jumped 70 percent and 105 percent, respectively, from their March lows.
- U.S. second-quarter corporate profits rose 5.7 percent from the first quarter. Nonfinancial corporate profits increased 4.5 percent, while financial profits rose 16.7 percent. Early indications for third quarter profits and sales in the US have exceeded expectations.
Vulnerabilities Remain
Despite the improvement in credit conditions, economic activity remains well below last year’s levels, with corporate defaults continuing to rise, unemployment worsening, and commercial real estate markets weakening. This is bound to further hit bank balance sheets and is likely to dampen the recovery in both credit and economic activity.
- According to Bain’s most recent forecast, the U.S. corporate default rate will reach 12 to 14 percent by the end of 2009, up from May’s forecast of 11 to 13 percent, with an additional 180 to 210 companies expected to default.
- Rising unemployment continues to hit consumer loan portfolios. Discover’s 30-day delinquency rates on credit-card loans packaged into bonds increased from 5.35 percent in August to 5.57 percent in September.
- With vacancy rates high and property prices falling, commercial real estate defaults are also on the rise. Foresight Analytics expects them to reach as high as $170 billion by the fourth quarter of 2010, up from $110 billion – or 6 percent of all such loans – in the second quarter of 2009.
Because of these pressures, projected credit capacity will be insufficient for meeting credit demand, according to the IMF.
- The IMF forecasts a difference between 2009-10 finance needs and expected capacity of 15 percent in the United Kingdom, 2.4 percent in the United States, and 3 percent in the Euro area.
Central Banks Remain Supportive
- Though many European and U.S. banks are repaying government loans, public guarantees and low policy interest rates still implicitly support them. Central banks may need to maintain such support if vulnerabilities persist.
- The Bank of Japan held its primary interest rate at 0.1 percent, while the Bank of Canada maintained a key interest rate of 0.25 percent and reaffirmed its plan to delay any rate increases until at least June of 2010.
- Australia’s central bank signaled that it is prepared to continue raising interest rates after its initial October 6 increase - the first rate hike among all G20 countries. Australian monetary policy remains expansionary, but members of the Reserve Bank said that maintaining exceptionally low rates is “no longer necessary, and possibly imprudent.”
Real Economy Indicates Broad Improvement
- U.S. retail sales declined by a less-than-anticipated 1.5 percent (m/m) in September, reflecting the expiration of the “cash for clunkers” program. Sales excluding autos improved by 0.5 percent, pointing to increased momentum.
- U.S. initial jobless claims fell to a 9-month low for the week that ended October 10, indicating that firings are moderating. Nevertheless, unemployment is expected to continue to rise, as hiring has yet to pick up.
- Investor confidence in Germany unexpectedly weakened as the German ZEW Economic Sentiment index fell from 57.7 in September to 56 in October.
Looking Ahead
For an update on the picture of economic conditions in the UK and interest rate decisions, look for the release of the Bank of England's Monetary Policy Committee meeting minutes on Wednesday, October 21, and UK's third quarter GDP report on Friday, October 23.
This analysis was produced by the editorial staff of the International Economic Bulletin, including Shimelse Ali, Vera Eidelman, Bennett Stancil, and Uri Dadush.
