Fear of a credit crunch intensifies

  • Turmoil. Yesterday's liquidity injection by central banks came amidst heightened fears of a global credit crunch. These were emergency interventions of a technical nature to ensure smooth functioning of money markets. This is not a sign that central banks are poised to reverse their monetary policy course yet (page 2-3). Fundamentals haven't changed. Risks of a self-fulfilling liquidity crisis, however, have clearly increased.
  • Solid. Companies and households seem, as we argued last Friday, resilient enough to weather the recent turmoil. This week our analyses focus on banks and the financial environment.
  • Banks. The credit crisis will undoubtedly leave its mark on bank balance sheets. Our analysis shows, however, that the vast majority of US banks are sound enough to be able to cope with the subprime-related losses (pages 4-6). The same should hold true for Europe.
  • Financial environment. Banks will continue to tighten their lending standards and increase risk premiums. That is also indicated by the latest ECB Bank Lending Survey (pages 7-8). The monetary and financial market environment will, therefore, get even tighter. Our Financial Conditions Index continues to rise (pages 9-10).
  • ECB. This will ultimately suit the central banks. As an immediate priority, of course, they will do everything they can to calm markets and prevent a confidence crisis from spiraling into a credit crunch. If calm is restored – still our baseline scenario – the ECB will have scope for further tightening. Later this year, the monetary & financial environment will be restrictive enough to bring growth back to trend (cf. chart).
Further topics:
    • Bank of England to tighten one more time (page 11).
    • Date outlook: Robust EMU growth in the second quarter; subdued inflation numbers in the US (page 12).
    • Market outlook: Financial markets remain highly volatile (page 20).

    ECB’s words and deeds – are they consistent?

    The ECB found itself in a tricky predicament yesterday, and we think it performed extremely well with its prompt emergency injection of liquidity just after reiterating its concern on inflation. The bank released its latest monthly bulletin in the morning, and the news screens flashed red with excerpts reiterating the basic message: the growth outlook is robust, “monetary policy is still on the accommodative side, […] overall financing conditions remain favorable, money and credit growth vigorous, and liquidity ample. “ Meanwhile, market rates were spiking as liquidity on the money market seemed to have suddenly evaporated: overnight deposit rates jumped to over 4.60%, a 50 bp spike. The USD Libor surged to almost 5.90% after being stable at about 5.35% for the last eight months (cf. chart). The ECB promptly stepped in, announcing it would provide unlimited liquidity at its target rate of 4.0%. About 50 banks participated in the auction, and the ECB injected around EUR 95 bn in liquidity. The last time the ECB had resorted to a similar emergency injection of liquidity was in the immediate aftermath of September 11, when it provided EUR 70 bn.

    The contradiction between words and deeds is only apparent. There is an important difference between an emergency provision of liquidity like yesterday’s and a relaxation of monetary policy. Yesterday, the ECB was faced with a potential confidence crisis. BNP had announced the closure of three subprime-hit funds; the German press reported that WestLB might have substantial exposure to subprime (WestLB later denied it); NIBC Holdings, a Dutch investment bank, announced a loss of EUR 137 mn on US subprime, and warned it might suffer further mark-to-market losses on ABS products. Some banks genuinely needed liquidity, in some cases to refinance conduit vehicles invested in ABS, and others probably tried to secure liquidity as a precaution, given the high level of uncertainty. With market rates spiking, serious concern was threatening to turn to panic. We have highlighted before that the current turmoil in financial markets has the potential to turn into a self-fulfilling crisis. Yesterday was a potential flashpoint, and the ECB promptly intervened to stabilize markets. Its example was followed later in the day by the Fed and by the Bank of Canada. This coordinated response clearly demonstrated the central banks’ determination to ensure the orderly functioning of financial markets.

    This, however, does not contradict the central banks’ monetary strategy, and here again the major central banks seem to be reading from the same script: ECB and Fed have reaffirmed their confidence in the global economy and their concern about potential inflation pressures; the Fed has indicated it will keep rates on hold, and the ECB has laid the foundation for at least another hike. The BoE similarly, indicated that another rate hike is extremely likely. The objective is clear and long-standing: to move the global economy to a new equilibrium with lower liquidity and more appropriately priced risk (i.e. higher spreads). This is why central banks keep referring to the current financial markets' turmoil as “a normalization of risk pricing”, to quote the latest ECB bulletin.

    The transition to this new equilibrium will necessarily be bumpy and painful, and central banks are aware of this. In fact, they probably believe that the pain is part of the learning process: the failure of some bad investments is a crucial input in the risk-repricing process. At the same time, central banks do not want the process to get out of control, and they certainly do not want it to degenerate into a full-fledged credit crunch. They will stand by to fine tune the adjustment, oiling the market mechanism as needed.

    We therefore see yesterday’s interventions by the ECB and the Fed as technical operations, aimed at ensuring the normal functioning of money markets, while at the same time sending a reassuring signal. We do not see them as a sign that central banks are poised to reverse their monetary policy course. Nor do we change our baseline scenario, which still envisages a bumpy transition to the new equilibrium, but without a full-fledged credit crunch.

    In terms of their impact on markets, the interventions are a double-edged sword: on the one hand, they should reassure investors that central banks stand ready to provide liquidity if needed; on the other hand, they might reinforce fears that the situation is more serious than central banks have acknowledged so far. Indeed, tensions heightened further between last night and this morning, with the overnight rate in the US spiking to close to 7%.

    Even in our baseline scenario, we still face significant volatility in the weeks ahead, with a high likelihood of wide swings in all major asset markets. It is far from over yet, and the current money market turmoil demonstrates in our view that the most recent rally in equity and credit markets was just another swing in this turbulent adjustment process.