Credit Markets Update: Fundamentals Driven or Too Much Liquidity?
What a difference a few months make. At the end of Q1 the financial world was staring into the abyss. Now, at the end of Q2, observers are asking themselves whether the next asset bubble is around the corner. This week’s newsletter reviews the recent performance of money and credit markets and asks whether the current performance drivers are likely to remain in place for the foreseeable future.
Now that the worst has been averted by central banks around the world, and especially those at the epicenter of the crisis (the Fed, the ECB, the Bank of England), observers ask whether this unprecedented amount of liquidity–which to date has mostly been hoarded by commercial banks in the form of excess reserves–is fuelling asset prices beyond their fundamental value, potentially leading to inflationary pressures down the line. The standard line of reasoning is that as long as the money multiplier remains low, the wall of liquidity created by central banks will not enter the real economic cycle in the form of loans to households and non-financial corporations. However, as economic activity and lending picks up, excess reserve holdings create a substantial risk of overheating and inflation.
To clarify this question New York Fed economists Todd Keister and James McAndrews recently published a report: “Why are Banks Holding So Many Excess Reserves?” One of the main conclusions of their report is that “no matter how many times the reserve funds are lent out by the banks, used for purchases, etc., total reserves in the banking system do not change. The quantity of reserves is determined almost entirely by the central bank’s actions, and in no way reflect the lending behavior of banks.” Moreover, “if the central bank pays interest on reserves at its target interest rate, as assumed here, the money multiplier completely disappears.” (Update)
Whereas the Fed has the ability to fine-tune monetary policy and inflationary pressures by choosing the appropriate path of interest paid on reserves, which is currently at 0.25%, the main lesson of the ‘Great Moderation’ was that the availability of ample funding liquidity makes the occurrence of asset price bubbles possible even in the absence of inflationary pressures. This puts central banks in a tight spot in terms of how and when to exit their quantitative easing programs. Whereas the Federal Reserve is said to be envisaging an exit from its Treasury purchase program within the next few weeks, the Bank of England surprised markets last week by extending its asset purchase program by another £50 ($84 billion). The ECB is completing its covered bonds purchase program and is monitoring the effect of its recent term lending operations.
Do lower interbank rates signal easy credit?
Government guarantees and commitments not to let any systemic counterparty fail are showing the desired impact in interbank markets, but they somewhat distort the character of the purely unsecured lending quote, or LIBOR, whose three month rate is the reference rate for the vast majority of variable rate financial products. As an example, while funding cost measures such as the LIBOR-OIS spread or the TED spread are at pre-Lehman levels (and are even approaching pre-crisis levels in the U.S.), other real activity indicators are not so upbeat. One example is bank lending standards, which are still in tightening mode, albeit at an easier pace. The July survey will provide further clues. Another indication that credit is not flowing easily to the private sector despite improved market sentiment is the ongoing contraction in bank loan growth. Indeed, the BIS and other researchers caution that as banks continue to delever, credit growth to the private sector might lag behind, denting any economic recovery.
Another important activity indicator in the corporate sector is the issuance of unsecured short-term commercial paper, with which financial and non-financial companies traditionally fund their day-to-day operations. As of end July, the outstanding financial and non-financial commercial paper volumes were almost half their respective peak levels and had returned to where they were in 2003. Observers note that stagnation in this segment signals very low real demand for business activity. There are finally some signs that demand for this short-term paper is reawakening, but observers note that especially financial institutions are hoarding the cash raised or using it to pay down debt. Asset-backed commercial paper–the short-term financing vehicle for SIVs and off-balance sheet conduits (before the run on those vehicles)–is still in free fall and points to ongoing difficulties in getting the over US$2 trillion securitization market going again on a sustainable basis (see Financial Innovation and Securitizations Come Back To Life: Business As Usual?)
Arguably one of the most spectacular turnarounds has occurred in the investment grade and high-yield credit markets since March 2009. Coincident with the equity markets rally, corporate bond markets reopened for issuance in Q2; the ensuing investment grade bonds rally completely reversed the selloff after the Lehman default. High-yield bonds are on their way there as well. Moreover, pricing anomalies such as a large negative basis between cash and CDS spreads have largely been reduced. Renewed liquidity in the credit markets led Moody’s to revise down its peak global speculative default rate to 12.2% expected by Q4 2009 from the current 10.7%. Importantly, it expects the default rate to decline sharply to 4.4% by July 2010.
Despite all the positive developments, observers note that the majority of high-yield debt issuance has been used to refinance existing debt, which is likely to put a dent on activity in the second half of 2009. Similarly, issuance activity in the investment grade segment also reflects a substitution for bank lending, where possible, and the ongoing desire to build up cash reserves. Going forward, sustained activity in the corporate sector relies on the performance of final demand. The same caveats apply for leveraged loans and CLOs–sectors that are an integral part of the private equity industry.
Above all, announced changes in the regulatory landscape, including for hedge funds, private equity, and derivatives and securitization markets, will contribute to an increase in overall credit costs. The secular trend towards lower nominal interest rates, which has sustained financial intermediation and credit markets in the past 25 years, has come to a halt.
No Responses to “Credit Markets Update: Fundamentals Driven or Too Much Liquidity?”
Nice work. Thank you. I’m sorry that nobody jumped on this in the comments section. I believe it’s an important question. Tyler Durden had a comment about the linkage between Open Market Operations and share volume a couple of days ago.You’ll have to explain to me the importance of multiplier. So, the Fed creates money, at no cost, which it extends to banks as reserves, which the banks then put on deposit with the Fed at interest which the Fed pays by creating yet more money – at no cost. Easy money, but no multiplier. I think understand that. The banks’ new-found wall of money and earnings do not enter the real economic cycle in the form of loans to households, etc.Yet supporting insolvent banks in this way is expected to trickle down, by way of the now normalized capital markets you mention, commercial paper, corporate bonds (both investment grade and other), leveraged loans and securitization markets. Paying interest on reserves would seem to suppress that, no? And the appearance is that it trickles UP to banking management anyway. There is some other leakage. At least in the UP direction. Probably also into shares & speculation. And probably in the DOWN direction too.Show me how this new liquidity can be withdrawn without putting the banks back to where they were last fall. And all of that bad bank debt has been assumed by the corporation and household customers of those very banks. Raising their costs. Not just their future funding costs. They have to pay what they already owe and what the banks have borrowed too. Not very promising going forward. Compound debt. You said, “Going forward, sustained activity in the corporate sector relies on the performance of final demand.” I hope it won’t be just US demand.So, maybe it’s true that we can create money to recapitalize the banks without it going into the real economic cycle and creating “inflation” (as defined by CPI). But somehow it’s apparent that commodity and asset prices (outside of real estate) are already increasing in dollar terms. And with no other explanation. The next asset bubble has already begun. But this new foundation is less stable. The balance sheet, in aggregate, is worse.“… the main lesson of the ‘Great Moderation’ was that the availability of ample funding liquidity makes the occurrence of asset price bubbles possible even in the absence of inflationary pressures.” Here I would hope to convince you to that asset price bubbles are as much a sign of inflation as increases in CPI. Increased liquidity IS inflation.
Banks’ excess reserves are held at the Fed on its liabilities side. On the asset side, the Fed is financing the direct Treasury and MBS purchases with these excess reserves (the lending facilities are receding). So the banks’ excess reserves do in fact represent additional market liquidity that enters the financial system but by bypassing the banking system. In Europe, the ECB’s balance sheet also increased. But by extending term loans to the banks, the ECB is trying to get the interbank market going again and revive the traditional credit channel through the banking system.