Noteworthy Market Developments since October 10, 2008
October 10 was a ghastly market day with equity prices hitting new lows, which reinforced prospects of a global economic slump. Stepping aside and looking at market movements since this momentous day, we see that there are positive and negative developments in financial markets that are noteworthy. Financial market spreads have narrowed in some cases. The spread between the 3-month Libor and 3-month Treasury Bill rate was down to about 238 bps as of November 3 from a high of 458 bps on October 10 (see chart 1). There is more room for improvement, but the direction and magnitude of change are significant.
At the long and risky end, junk bond yields have moved up sharply but the peak appears to have occurred on October 27, 2008 (15.7% spread), with the spread at 15% on November 3 (see chart 2).
The spread between the 2-year swap rate and 2-year U.S. Treasury note yield is down to 114 basis points from 169 bps on October 3 (see chart 3).
Equity prices appear to have retraced a small part of losses since the low on October 10, 2008 in some countries, while others show a continued downward trend. The S&P 500 closed on October 10, 2008 at 899.22, down 42.6% from the peak on October 9, 2007; as of this writing it was trading at 1000.84.
Equity prices in China, India, and Russia have posted new lows after October 10, 2008. The Dow Jones Global Index excluding the U.S. hit a new low (126.73) on October 26 and closed slightly higher on November 3 (149.06, see chart 5).
Mortgage rates have risen nearly 50 bps since a low of 5.94% October 10 (see chart 6), which is certainly not a positive change for the housing market.
Amid the mostly mixed news, there has been a mostly steady improvement in the trade weighted dollar. As of November 3, the trade weighted dollar stood at 82.04, up 18.4% from a low of 69.28 on March 17, 2008 (see chart 7). Although the first anniversary of the onset of the current crisis is behind us, the main conclusion from these charts is that financial market stability is not here yet. A complete resolution should take several more months.
Australia: Strong Rate Cut, Bold Statement About Economy
In the latest of a string of rate cuts throughout the world, the Reserve Bank of Australia lowered its Overnight Cash Rate (OCR) by a surprisingly-strong 75 basis points, to 5.25%. The consensus forecast was for a less urgent 50 basis points, and analysts dove into the accompanying statement in search of any worrying words or phrases that would cause alarm. We did as well, and it was what we did not find that intrigued us the most.
The statement went to great lengths to recognize the global market turbulence and widespread wealth destruction of the past months, which hardly count as news anymore, but it also juxtaposed Australia’s relatively hardy economic situation against the world’s problems to show how the local economy has persevered. More importantly, the statement made no reference to an upcoming recession, which has became part of the standard text for most of the industrialized world. While the RBA discussed economic moderation and lower rates of activity, it highlighted how certain imbalances in Europe and in the USA (read: housing market overvaluations) were not as dramatic in Australia, and how fiscal and monetary policy had ample room to offer stimulus.
Australia’s most significant imbalance through the years has been a significant current account deficit that has on occasion reached 7.0% of GDP. Our main concern was if the Australian dollar went through a sharp or sudden decline, the increased pressure on the external balances would drain away liquidity and drag down the economy. However, the recent liquidity crunch has dampened economic activity and thus import demand, which subsequently narrowed the current account deficit. Liquidity is still tight, but the external imbalance is correcting in a way that gives the RBA room to maneuver and lets the Aussie dollar depreciate, making exports more competitive and supporting growth. The economy is decelerating, but it may just avoid its first quarter of contraction since Q4 2000.
Looking forward, we believe the OCR has more room to fall, and the RBA could easily participate in any coordinated global rate cuts this year. By end-June 2009, most people are placing the OCR at 4.00-4.50%, and we place our bid at the lower end of that range. We also believe that Australia will avoid a formal, two-contracting-quarters recession, as monetary, fiscal and now exchange rate stimulus will all sustain a low level of expansion. Downside risks do exist – particularly any second-round impact of liquidity tightening and possible bank failures – but we insist that the country is in better position than most of the G-7 to handle such problems without severe economic pain.
