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Economics Weekly - How will the credit market turmoil unfold; Weekly economic data preview - Key central bank speakers to give guide on official interest rates

Economics Weekly  27 August 2007


How will the credit market turmoil unfold?


What will be the economic impact of the current credit market cycle?

 We have calculated the negative impact of the current global credit market event on the UK economy to be 0.1% - to 0.3%, depending on how long the turmoil persists and how pronounced the impact is on credit spreads and hence corporate borrowing costs. If the turmoil lasts for just 2 quarters, then the effects are negligible, but if it persists in corporate bond spreads and equities for a year then the impact will be to reduce economic growth by up to 0.3 of a percentage point in 2008. Based on our forecast of 2.3% for 2008, this would reduce UK gdp growth to 2% from nearly 3% this year.


The crisis may even be confined to the financial markets

Since there is so much uncertainty currently about whether the financial market crisis will be ring-fenced in the credit market (there are some signs that the crisis may be fading already in the equity and currency markets), we thought it might be useful to see how previous market shocks, like the one this credit crisis has precipitated, evolved in relation to a range of market and economic variables, including corporate bond spreads and equities. This will enable us to capture the likely consumer and corporate impact of the volatility.


What does the history of equity market volatility in the last 20 years tell us about the current financial market turmoil?

Chart a identifies only one fall (1991/92) that is similar to the present experience, when equity prices fell by 11%. The fall so far in this crisis has been just 10%, like the 1991/92 event from which there was a subsequent rise of 51% from a trough in 1992 to a peak in 1994 (a crash is defined as a fall of over 15%).  let us look at two other periods of equity market turmoil and see what happened to some other key economic and market variables in the 12 months following the fall from peak to trough. Chart b shows that in 1998, the equity market ended the year higher, although the December 1999 fall has so far not been fully reversed (the drop was 50% from peak to trough). The current equity market decline looks small in relation, and has already reversed some of its losses.


Are equity markets already making a comeback and will the effects of the credit crisis be short lived?

Chart c shows that one reason why the 1998 equity market recovery may have taken place is because of a sharp fall in short term interest rates. Twelve months after the 1999 event, interest rates were about the same level as at the start. Since May this year, there has been a rise in UK bank rate but it is still lower than in the 2 previous episodes of market turbulence examined here. Chart d shows that bond yields are also lower now than they were in 1998 or 1999; these two indicators suggest that the equity market decline may well be short-lived. Interestingly, corporate bond yield spreads, one of the key drivers of the transmission of any shock from the credit market crisis to the company sector and hence the real economy, at the moment are still below those in the other two market events. One reason why the UK central bank will not cut interest rates unless there is a full blown crisis, is shown in chart f, which highlights the fact that UK price inflation, although just below the 2% target at 1.9% in July, is not as low as it was in 1998 or 1999. Chart g shows that industrial production did fall in 1998 and 1999 but that may have been because spreads were wider than they are at present and short term interest rates were higher. The current rate of industrial production is mid way between the 1998 and 1999 outcomes and barely rising by 0.5% pa, but the risk is that growth weakens from now on as it did then, before the next 12 months are over. Finally, what of retail sales? Chart h shows that sales do not really respond as much as many would have thought to equity market turbulence. Currently, sales are robust, though the 1.25% rise in base rates since August 2006 has yet to fully impact and so will likely weaken, perhaps sharply, over the coming 12 months. Whether that will be more to do with the rise in interest rates than the credit market crisis remains to be seen.


There may be little or no impact on the UK economy

Our analysis implies that the current credit market crisis is not as damaging for the UK economy or for the corporate sector as many suppose. However, the global credit market crisis might yet lead to a cut in interest rates, an economic recession, weaker stock markets and a sharp rise in company defaults, but that is not what our analysis suggests it means for the UK. Globally, this implies the US Fed keeps its benchmark interest rate on hold, the ECB hikes in September but the UK leaves base rates on hold at 5.75%.


Trevor Williams, Chief Economist


Weekly economic data preview


Key central bank speakers to give guide on official interest rates


We expect data this week to highlight that the global economy remains robust and the impact of the recent financial market volatility has been limited, so far. This should also be the main message from key speakers this week, including Fed chairman Bernanke on Friday and ECB president Trichet on Monday.


• Continuing tough credit conditions and high money market cash rates highlight that financial markets remain nervous about the potential fallout from the US sub-prime crisis. However, it is interesting that equity markets globally have rebounded and the carry trade has resurfaced in currency markets. It is likely that the latter corrections are a sign of what may occur in credit markets once the current liquidity log-jam ends. However, given the looming uncertainty, it is understandable that safer government bonds have performed well, pushing yields sharply lower, while riskier markets, such as asset-backed commercial paper, have suffered most.


• The ongoing dislocation in money markets has primarily kept open the debate about whether a further response is required from some central banks - particularly a cut from the Fed and for the ECB to hold its interest rate at 4% next month, rather than a hike as signalled. Interest rate futures still predict a higher probability of a Fed cut at the September 18 meeting than of a hold, while the odds of an ECB hike on September 6 have increased since last week. We still believe that with no clear signs yet that the real economy is at serious risk, financial markets may be disappointed. We predict US interest rates will stay at 5.25% this year and the ECB will hike to 4.25% next month, assuming market conditions do not worsen.


• However, economic figures from the UK will also be watched for signs that the 1.25% increase in interest rates since August last year are having a dampening effect on the economy. We expect both mortgage approvals and lending to be lower in July, albeit still quite strong. Nationwide house price growth may have eased in August to 9.3% - the slowest rate since March. The Gfk consumer confidence index is predicted to have dipped for a third straight month in August to -7, in line with the results of our own Lloyds TSB Consumer Barometer.


• The second estimate of Q2 gdp is the main data highlight in the US this week. Annualised growth is expected to be revised to 4% or above, from 3.4%, the fastest pace since Q1 2006, reflecting recent better than expected trade data. The core PCE deflator is forecast to rise back to 2% in July, ending a four month easing run. Both sets of data should highlight why the Fed remains reluctant to cut interest rates. This view should also be reinforced by the FOMC minutes of the August 7 meeting.


• In the euro zone, the German IFO survey is expected show that while the recent volatility in financial markets has hit confidence, it still remains consistent with solid growth in the economy. We look for a fall to 105.8 in August, from 106.4, but it could be sharper after the weak Zew survey last week. A rise in annual money supply growth to 11.1% - a 17 year high, should further underline why the ECB will not want to change its position on interest rates.


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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