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Forex Market News - Economics Weekly: How much at risk are credit markets from rising interest rates? Weekly economic data preview: What does inflation data imply for interest rates?

Economics Weekly:

How much at risk are credit markets from rising interest rates?

After about a decade of frenetic activity, will the rise in inflation, short term interest rates and bond yields finally check credit growth? With central banks around the world raising interest rates in response to higher inflation and fast growth, monetary conditions are getting tougher. The clear implication is that borrowers should beware the consequences of higher costs. It implies that relative returns may not be as high and that risks are greater. Credit markets have thrived during the recent period of historically low interest rates and financial market stability, which has allowed narrow risk spreads and low expected market volatility. Since 2002, the global equity market index has doubled in value; the emerging market equity index is up 237%; the metals index by 234%; the spread between investment grade bonds compared with US treasuries has fallen by 112 basis points, on sub investment grade debt by 561 basis points and on emerging market bonds by 643 basis points.

Is the benign credit environment under threat from rising interest rates and greater financial market volatility?
Ultimately, asset prices - and derivative instruments count in this category - depend on the performance of the real economy. So what can go wrong in these markets now that short term interest rates and bond yields are rising? The answer is, quite a lot. The sheer size of the assets involved illustrates the risk to other parts of the financial system since leverage is so large in derivative markets. If liquidity were to become less plentiful, the risk has to be that funds that are overly leveraged could see their investments lose value and very quickly fall into a position of negative equity. Financial institutions that are exposed to the sector and might have lent on narrow spreads, weak risk assessment standards or weak covenants, could also find themselves at risk of rising indebtedness and non recoverable losses. This could have knock on effects on the real economy via tighter overall credit conditions and lack of liquidity for companies and higher borrowing costs than would otherwise be the case, exacerbating any economic downturn.

In the last seven years, global liquidity or money supply growth has been exceptionally rapid...
Money supply remains high today, at between 8 and 10% annual increase, see chart a. The background of course has been rapid growth in the global economy and the accumulation of huge amounts of foreign reserves in the emerging market economies and in the oil and commodity exporters. But in the developed economies themselves, sustained robust global economic growth since 2002 has translated into strong growth in profits and rising asset prices, which in turn have led to increased wealth and so to even greater liquidity. This rise in wealth has meant the flow of funds into a range of assets, new and old, has been unprecedented. Chart b illustrates this, showing that stock markets are now mostly exceeding their peaks of 1999, just before the IT induced collapse. Chart c shows that an even stronger rise in equity prices is occurring in the developing economies, with chart d highlighting the rise in commodity prices as global demand has soared alongside faster economic development. In addition, new asset classes, including for commodities, have also been created as a result of greater liquidity. Chart e is a measure of property prices in economies that account for some 60% of global economic output. At a minimum, they are up by some 50% above their 1995 average and, in the case of the US, have doubled.

...increasing the risk of a sudden reversal
To give an understanding of the scale of the potential for problems in these new markets, we show a series of charts that summarise the outstanding levels of debt in a variety of financial instruments. First, however, what is the underlying asset position of the instruments on which so much derivatives have been built? Chart f shows that at the end of 2005, the value of global equity markets was $41 trillion and that of bonds, government and corporate, was $44 trillion. But this was vastly overshadowed by the notional amounts outstanding on derivatives, which stood at over $450 trillion at the end of 2006. Implying leverage 5 times that of the total value of equity and bonds. Within this total of $450 trillion, interest rate instrument (mainly swaps) were by far the most popular at some $300 trillion. Foreign exchange derivatives were next, then credit default swaps and equity linked and commodity based instruments. Chart j shows that the rate of expansion of credit default swaps in terms of its progress is matching that of the development of the interest rate swap market. For some observers, it is this latter development that is of particular concern since it changes the relationship between the holders of debt and the original issuers, perhaps making it harder to resolve debt defaults should there be a surge in company bankruptcies in some future economic downtown. Will this happen soon? Clearly, this is hard to predict, but the current rapid pace of global economic growth and the still relatively low level of interest rates and inflation means that a recession is unlikely this year or next. So higher interest rates are unlikely to derail credit markets but may slow their growth.

Trevor Williams, Chief Economist

Weekly economic data preview

What does inflation data imply for interest rates?

• Inflation figures for the UK this week may have influenced the MPC to keep Bank rate on hold at its June meeting. We will know more about what influenced the decision when the minutes are released next week.

• UK CPI has been above the BoE's 2% target for twelve consecutive months but indications are that it may have already peaked at 3.1% in March. We expect the annual rate to ease to 2.6% in May, from 2.8% in April and forecast it to be back on the 2% target by December. This is one of the main reasons why we predict Bank rate may not need to be raised to 5.75% or higher, though this view is dependent on data trends each month.

• Growing signs that the US economy is on a stronger footing in Q2 have led the financial markets to pare back expectations of a cut and seriously consider higher interest rates in 2008 (this has been our long-standing view since Q4 2006). Global bond yields have followed treasuries higher and a palpable degree of market risk aversion finally appears to have returned. Data from the US this week will be digested with two things in mind: how strong could growth be and will inflation slow further? We expect to see a strong rebound in retail sales in May, annual core consumer prices may have edged higher and capacity use is set to remain tight. Could bond yields test the highs of last week?

• Stronger growth is expected to lead the SNB to raise its 3-month target rate to 2.5% on Thursday. The BoJ is widely expected to leave interest rates unchanged at 0.5% on Friday, on weak inflation.

• Economic data from the euro zone are unlikely to be market-moving this week but will add further support for higher interest rates. ECB speakers this week include president Trichet.

As expected, the Bank of England (BoE) refrained from raising Bank rate to 5.75% last week. The latest Bloomberg survey shows a large minority of around 30% of economists expect a hike next month, but this could be even lower by the end of the week. The BoE MPC are likely to have had a preview of the May inflation data and this has led to speculation that the annual CPI rate may have declined again to help keep them sidelined last week, but this may be reading too much into one month's figure. However, based on our analysis, the annual CPI rate may have eased to 2.6% in May, from 2.8% in April. Data on this is due on Tuesday, but whether the outturn influenced the MPC will not be known until the minutes of the meeting are published on June 20th. We believe there is a chance that the annual rate slowed to 2.5%, this is slightly below the market median estimate of 2.6% and could elicit strong market reaction.

There are other key UK data this week that could influence market predictions of how high and how soon Bank rate could rise in the months ahead. Although a hike to 5.75% is generally considered odds-on, we believe that emerging data trends are crucial and that the need for abase rate rise to 5.75% is still not conclusive. As well as slowing CPI inflation, we are concerned that the impact of previous interest rates rises will increasingly weigh on consumer spending and so overall growth. There are already signs that housing market activity has moderated and the outlook for consumer spending is further clouded by the potential impact of the payment shock facing large numbers of home owners moving from comparitively low fixed rate mortgages a few years ago to a current situation of sharply higher interest rates. However, retail sales in May are forecast to have rebounded by 0.3%, after surprisingly falling by 0.1% in April. The other key data this week are the labour market statistics. The figures should show that one of the main fears of the MPC, escalating wages growth, has failed to materialise so far and pressure from this source remains subdued. We forecast underlying average earnings growth stayed at 3.7% in April, still well below the BoE's 4.5% reference rate.

A quiet start to the week for US data should allow participants time to consider the large market swings last week, particularly in the bond market. However, the data are likely to add further weight to the view that US interest rates will not be cut this year. May PPI data on Thursday could see strong reaction, but the focus will be on the CPI figures on Friday. We look for annual core CPI to rise to 2.4% in May, underlining that inflation pressures remain elevated. Retail sales in May, out on Wednesday, should show a solid rebound after the surprise fall in April, indicating that consumer spending is underpinned. The Q1 current account and April capital inflows data will draw attention on Friday.

Economic data and events in the euro zone are likely to have only limited financial market impact this week.

Jeavon Lolay, Senior Economist

Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE,
0207 626 - 1500

Any documentation, reports, correspondence or other material or information in whatever form be it electronic, textual or otherwise is based on sources believed to be reliable, however neither the Bank nor its directors, officers or employees warrant accuracy, completeness or otherwise, or accept responsibility for any error, omission or other inaccuracy, or for any consequences arising from any reliance upon such information. The facts and data contained are not, and should under no circumstances be treated as an offer or solicitation to offer, to buy or sell any product, nor are they intended to be a substitute for commercial judgement or professional or legal advice, and you should not act in reliance upon any of the facts and data contained, without first obtaining professional advice relevant to your circumstances. Expressions of opinion may be subject to change without notice. Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. The facts and data contained are therefore not intended for the use of private customers (as defined by the FSA Handbook) of Lloyds TSB Bank plc. Lloyds TSB Bank plc is authorised and regulated by the Financial Services Authority and is a signatory to the Banking Codes, and represents only the Scottish Widows and Lloyds TSB Marketing Group for life assurance, pension and investment business.


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