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The future's beginning to look much brighter than before. Over the past couple of weeks, we've seen some indications that the worst of the credit crunch is over. Among them:
The future's beginning to look much brighter than before. Over the past couple of weeks, we've seen some indications that the worst of the credit crunch is over. Among them:
• | Market expectations have shifted toward the possibility of the Fed increasing interest rates, beginning in September. | | | • | Stocks have been on a tear, with the Dow up almost 9% since the middle of March. | | | • | Bond market volatility (daily price swings of bonds of all sorts) has declined. | | | • | The market's perception of banks' creditworthiness has improved to February levels. | | | • | The spread between key interest rates and Treasury yields has also been improving. |
If these positive trends continue, short-term rates are likely to go up later this year. We do not expect longer-term Treasury rates to increase at the same pace. Remember that as Fed Chairman Ben Bernanke pointed out last week, markets are still far from normal. The modest easing in credit is only part of the story. The outlook for housing and the economy still has bond investors a little spooked. Consumers haven't seen daylight yet
Home prices continued to fall last month, and foreclosures increased 65% over April 2007. As if the rapid decline in their home equity weren't enough, two other factors combine to make homeowners feel poorer: 1. | | Debt. In 2006, the loan-to-value ratio of the average U.S. household (total debt divided by total housing value) was over 50%, compared to 26% in the U.K. and 9% in Japan. | | | 2. | | Inflation. The rise in prices (milk up 13% since last year, eggs up 25%, gasoline up 23%) is taking a heavy toll on consumers' spendable income. |
As a result, consumer confidence has sunk to the level of June 1980. Back then the Iran hostage crisis was in its eighth month, President Jimmy Carter had just signed the Crude Oil Windfall Profits Tax Act, and the Dow was below 900 points. As we know, the '80s went on to be a period of great economic growth. Let's hope history repeats itself. Business banks still have a tight grip on the purse strings
Today, almost 60% of banks report tighter standards for commercial and industrial lending. That's slightly more than the number reporting tighter mortgage standards. Because of the historically strong association between available business credit and employment levels, this is not a promising sign for economic growth. Why the Fed can't just keep cutting rates
You may be wondering, "If the economy gets worse, won't the Fed just keep cutting rates?" But two possible downsides make this a tricky choice: 1. | | Inflation. If the Fed keeps rates too low for too long, the economy could eventually overheat, causing prices to rise too fast. (Think of trying to drive with one foot on the gas and the other on the brake.) This week's inflation data suggest that the economic slowdown may indeed be relieving some of the pressure on prices. But one week does not make a trend, and the Fed has clearly signaled its concern about prices. | | | 2. | | A further decline in the dollar. Reducing short-term interest rates lowers the return received by foreigners who invest in Treasury bills and other dollar-denominated debt. In the past, the U.S. dollar has been such a symbol of safety and strength that we've not had to worry about Fed rate cuts affecting its appeal. But as our creditors' own economies grow stronger, they may feel pressure to seek higher returns elsewhere. If they decide to stop buying our debt, we'll have to pay higher interest rates to entice them. With less demand for the dollar, its value will drop, which in turn will increase the price of imports. The result: more pain for consumers. |
If the Fed does cut short-term interest rates further, we'll probably see long rates rise as inflation anxiety prompts investors to sell 10- and 30-year Treasuries. Higher long-term rates will make mortgages more attractive to domestic banks, a development that could take up any slack in the market caused by foreign selling. In this scenario, ARMs will look more appealing to investors, while fixed-rate mortgage yields stay in a relatively tight range. It's not clear which path we're going to end up on. But until the data tells us that we need to worry about a deeper recession, the future certainly looks a lot brighter than it did a couple of months ago.
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