A year on from the collapse of Lehman Brothers, the financial markets may feel there is a case for ending emergency measures. But the liquidity taps are unlikely to be turned off in the near future.
The world economy has come a long way since the beginning of the year when there were fears of another Great Depression. Today the talk is of recovery and economists have been scrambling to upgrade their forecasts for growth.
As we move into the final quarter of the year it is widely accepted that the recession is over and that the world economy will enjoy a bounce from the inventory cycle. This is a classic feature of business cycles where, having run down their stocks of unsold goods, companies restart production, providing a substantial kick to activity.
Risk assets have performed well, with developed market equities up more than 50% since the March lows and credit rallying strongly in response to the change in growth expectations. In many cases the rally has been led by the financial sector itself, as investors recognise that the banks are on the mend. The worst of the write-offs from the credit debacle now appear to be behind us and operating earnings have improved significantly, helped by the combination of low interest rates and a steep yield curve.
That environment has been fostered by the world’s central banks. Policy rates in America and Britain remain at record lows, while the central banks of both are engaged in quantitative easing – the process of boosting the money supply by purchasing assets using newly-created money.
Such support has helped fuel the rally in markets, which in our view are being increasingly driven by liquidity as investors seek to escape the negligible returns available on cash. Look no further than the gap between Fed funds and corporate bond rates to understand why the flows into credit funds remain so strong (see chart).
However, one year on from the collapse of Lehman Brothers, there is a case for removing the emergency measures put in place to counter the seizing-up of the financial system at the end of last year. The original crisis has largely passed and, with the improvement in growth expectations, the case for policy support has weakened. After all, central bankers are supposed to remove the punch bowl just when the party is getting going.
Judging from their latest statements, those who control global interest rates are some way from calling for last orders. In the statement following its policy meeting of August 12, the Federal Reserve acknowledged that the American economy was “levelling out”, but said that it “continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period”.
In Britain, the Bank of England also acknowledged that the economy was approaching a trough and that credit conditions were thawing but, following downward revisions to GDP, said that the output gap, and hence deflationary pressure, had increased. In response, it decided to increase quantitative easing, a move that could be seen as equivalent to a cut in interest rates.
The Bank of England is probably at the dovish end of the spectrum. However, along with the Fed, the European Central Bank and Bank of Japan have signalled that it is too early to be embarking on an exit strategy from current policy settings.
Underpinning this view are doubts about the sustainability of the recovery, given the continuing weakness of final sales and credit growth, a benign outlook for inflation and fears of repeating the mistake of Japan in the 1990s by tightening too early.
Such caution is not unusual even in a normal cycle where there is a considerable gap between the first signs of recovery and tightening. In America, the unemployment rate normally peaks and falls for some months before the Fed begins to tighten (see chart). At present unemployment is still rising in America and, on our forecasts, will not peak until mid-2010.
All this strongly suggests that the liquidity taps will not be turned off for some time as the first priority of the central banks is to provide the right amount of liquidity to the real economy, not the financial markets. Clearly this is good news for equities and credit which can continue to benefit as investors flee cash.
It also raises the prospect of increasing strains on policy in those economies, primarily in Asia Pacific, where currencies and hence interest rates are tied to the dollar.
These economies largely avoided the credit crunch and subsequently experienced less of a downturn. However, the result is a mismatch between loose policy settings and strengthening domestic economic conditions. The risk is that this creates inflation, or an asset price bubble as liquidity flows unchecked into the region.
It is notable that one economy in the Pacific which does have an independent monetary policy has already indicated that it will be raising rates in the near future. That economy is Australia.