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Credit Market Analysis - UK corporate credit conditions (I) - parallels with 1998 LTCM crisis
Credit Market Analysis 3 October 2007
UK corporate credit conditions (I) - parallels with 1998 LTCM crisis
A period of easy money in the last few years, caused by low global inflation and interest rates, resulted in increased risk-taking among investors. This search for yield compressed corporate credit spreads relative to risk-free government bond yields to unusually low levels in the past 3 years or so. More recently, spreads have widened again, as problems stemming from the US subprime mortgage market spread to the wider credit markets, hitting the financial sector in particular, see chart a on the next page. The increased risks to the wider economy has also resulted in widening non-financial credit spreads and prompted the US Federal Reserve to reduce interest rates by half a point on September 18. Markets expect further interest rate reductions by the Fed, while the ECB and Bank of England are expected to keep rates on hold in the remainder of this year.
Parallels with the 1998 hedge fund crisis, as central banks reduced interest rates...
There are interesting parallels with the LTCM (Long-Term Capital Management) hedge fund crisis in 1998. Then, as now, the downside risk to the wider economy from a credit crunch in global financial markets led the Fed to reduce interest rates in September 1998 from 5.5% to 4.75% by the year-end. The Bank of England also slashed interest rates from 7.5% to 5% by mid-1999, as chart b shows. But will the UK follow the US this time?
The policy easing in 1998/99 helped prevent a sharp economic downturn and we could see a repeat of that happening again this time. Indeed, we expect US economic growth to accelerate, not decelerate, next year to around 2.5% from 2% this year. In the UK, we expect a moderate slowdown in growth in 2008 to around 2.3% from 3% this year, enough to allow lower rates.
...but this ultimately led to the dotcom boom and subsequent crash and recession of 2001
Former Fed Chairman Alan Greenspan recently drew parallels between the 1998 LTCM crisis and the current subprime crisis, and noted that financial market bubbles are driven by human nature and are difficult to temper with policy actions. By cutting interest rates in 1998 to counter downside risks to economic growth, the stock market took off, ultimately leading to the dotcom bubble and the subsequent crash and global recession of 2001 (chart c).
If these parallels are correct, policy easing by the Fed and other central banks will support economic growth next year, but risks stoking a renewed bubble in the financial markets, unless US and euro zone monetary policy is tightened in 2008 (the UK already has high interest rates after the five rate rises between August 2006 to July 2007). After all, from a historical perspective, nominal interest rates are still low and liquidity at the macroeconomic level is still ample.
Hann-Ju Ho, Senior Economist
Economic Research,10 Gresham Street,
Lloyds TSB Corporate
London EC2V 7AE,
0207 626 - 1500
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