• All clear? Massive intervention by governments and the untiring efforts of central banks have succeeded in halting the downward spiral on money markets. And the odds of – not sudden but – sustainable relief in the coming months are pretty good (page 2). But risky assets are still under pressure. 

  • Pressure. The ongoing financial crisis will, therefore, be a tangible drag on the global economy also over the medium term. A return to the growth dynamic of recent years any time soon is not in the cards. First and foremost in the US, tighter lending standards (cf. chart) and negative wealth effects are a major drag.

  • Revision. There is strong evidence that the third quarter will already witness the strongest slump in private consumption since the 1990/91 recession. This slump is likely to continue well into next year. At the same time, the corporate sector is facing strong headwinds. Accordingly, we have lowered our forecast for US growth in 2009 to 0.2% (pages 3-9).

  • Support. A deep, full-fledged recession in the industrialized world still tends to remain a risk scenario. Even though the road to stabilization in the course of next year will be rocky, there are nevertheless important support factors, such as the drastic downward correction in commodity prices, new fiscal packages and, last but not least, further monetary policy easing. The Fed will step in as early as next week by lowering its target rate by another 50 bp to 1%.

  • Further topics:

    – Italy: On the brink of a recession (page 10).

    – Data outlook: EMU inflation to retreat strongly (page 12).

    – Market outlook: USD to remain firm (page 19).


Fever

The fever is receding, giving hope that money and interbank markets have escaped the life-threatening phase and are now on the path to a gradual recovery. The 3-month USD Libor rate dropped by 130 basis points and the 3-month Euribor by 46 basis points over the last two weeks, that is since the coordinated announcement of rescue packages by European governments; 3-month Libor-OIS spreads have narrowed by 105 bp in the US and 12 bp in the eurozone. The decline is significant and has been sustained long enough that we can be confident that this is not just an enthusiastic announcement effect but a genuine sign of normalization.

Equally important, there are some tentative signs of actual interbank lending taking place. To be sure, in Europe banks are still redepositing large amounts of liquidity with the ECB, paying a negative carry for the peace of mind of quickly accessible cash, and proving that conditions are still far from normal. But the fact that some interbank lending is resuming shows that faith in the banking system is gradually returning and that perceived counterparty risk is diminishing, thanks to the governments’ strong commitment to underpin the financial sector.

Policymakers continue to prove up to the task. The ECB is playing a pivotal role in sustaining a continued improvement in liquidity conditions, through term funding auctions and the unlimited provision of euro and dollar liquidity. This strategy has been, in my view, essential to maintain momentum while the measures launched by national governments take effect. For their part, governments are persevering in their efforts to hone and sharpen their measures to ensure maximum effectiveness. However, we are now facing two key challenges.

First, markets now need a lot of faith to believe that policy action has not come too late to avoid a deep and prolonged recession. Macroeconomic data have taken a turn for the worse everywhere: in the US, Bernanke called for a second fiscal stimulus package; in Europe, the IMF and most other forecasters predict little if any growth next year; central and eastern European economies are slowing and showing signs of stress; China’s GDP growth decelerated more than expected in the third quarter. The hard truth is that there is nothing that policymakers can do to influence economic data over the next few months. Those data will continue to show a worrying and widespread loss of momentum, raising fears that policy action is ineffective, too little too late. Such fears are, in my view, excessive, and we need to bear in mind that the policy actions already taken are powerful, and more will quickly follow in the shape of aggressive interest rate cuts and fiscal stimulus measures. Moreover, the global economy is down but not out. China’s disappointing Q3 growth rate was still an impressive 9%, showing that emerging markets are losing momentum but not grinding to a halt. And in a more balanced global economy, the resilience of emerging markets provides precious support. In the US and especially in Europe, the worst fears are linked to the risk that a fullfledged credit crunch might exacerbate an already serious slowdown. But given the strength of recently enacted measures, and governments’ clear determination to follow up with more, a credit crunch will be avoided.

Second, ongoing deleveraging is now the biggest threat. Policymakers’ actions are proving effective in stabilizing the banking sector, but the “buy side” of the market is now bearing the full brunt of the spike in risk aversion. The danger is that we might see waves of redemptions as liquidity flows out of investment funds and into the safe haven of a guaranteed banking system. These would imply forced liquidations of assets and further downside pressure on asset prices, making it that much more difficult for markets to recover. This unfortunately might already be underway, and might explain some of the persistent pressure on equities as well as the sudden loss of appetite for emerging market assets. Banks could try to shield themselves through a weakening of mark to market rules, but a disorderly acceleration of the deleveraging process would clearly pose a serious risk to the stabilization of the broad financial system as well as to market, consumer and business sentiment. There is no easy solution here, and perhaps the only hope is that a faster stabilization of the banking system could bolster confidence that underlying economic conditions will bottom out soon, and attract a solid bid from strong investors including large real money funds and sovereign wealth funds.