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The impact of credit (or absence thereof) on the real economy

|Includes: SPY, iShares 20+ Year Treasury Bond ETF (TLT)
Having defended since the beginning of this crisis the theses of Hyman Minsky, who (to my knowledge) was the first to extend Keynes’ macroeconomic analysis to our highly modern, financiarised societies via his studies of the correlation between the expansion (contraction) of credit and the surge (contraction) of asset prices, I have been continuously monitoring the evolution of credit in the major economic markets, particularly, in the eurozone, which concerns more directly our clients.
      This analysis is all the more important, since the differences in predictions of the Fed’s and the ECB’s monetary policies have never been so great, not to mention the anticipations on the long parts of yield curve!
 
 
     Since we’re on the topic, we consider just one point in yesterday’s press release by the Fed to be noteworthy.   
      Here it is:
 
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.
 
      The yellow part is that added by the Fed in this latest release.
      This is what I tend to think of this inclusion:
 
  • In recent weeks, Fed officials have been harassed for weeks on a very precise question:
 
      What are the key variables in their analysis of the economy and what kind of upturn would lead them to reverse their currently very accommodating monetary policy (interest rates at 0%)? (The QE issue seems to be solved with the announced end of the buyback programmes in Q1 2010).
      They have systematically refused to answer this type of question, probably to avoid tying their hands, so that they can act more forcefully should the situation change earlier than expected.
 
·        This passage referring to “extended period” (a minimum of six months) seems to contradict the fears of some of a tightening of criteria favoured by the FOMC (low rates of resource utilization, subdued inflation trends, and stable inflation expectations). The Fed is thus giving assurance to the most monetarist board members and to investors worried about an ultra-Keynesian turn by a Bernanke tempted to do “whatever it takes” to avoid a Japanese-style deflationist trap.
 
·        But this is where understatement become art. By highlighting utilisation capacity and the output gap, Mr B pulls one off on the monetarists in question.
      The latter, who worry about the often debated difficulty of measuring the output gap, would have undoubtedly preferred a more objective variable, such GDP growth.
      This is what St Louis Fed chief Bullard had to say on the matter in his 11 October speech before the NABE congress:
 
I am concerned about a popular narrative in use today -- the narrative being that the output gap must be large since the recession is so severe. And so, any medium-term inflation threat is negligible, even in the face of extraordinarily accommodative monetary policy.  I think this narrative overplays the output gap story.
 
      (For those who want to enjoy their weekend, I have included some very instructive links at the end of this note).
 
·        As such, by using the term “resource utilization, Mr B conveniently left himself a way out, since the unemployment rate can be included in the output gap.
 
      This tallies with our “very extended” bias on Fed policy. As such, we are still unable to offer option strategies on frankly downward stock market indices, because risky assets will continue to benefit as long as the money keeps flowing.
      In contrast, the mega-optimists on the economy (partisans of a V-shaped recovery and others who seem to be unaware of the particular nature of recessions accompanied by a general credit crisis) would be wise to be avoid being taken in by seemingly favourable statistics, such as those on the labour market! They could push the Fed to tighten interest rates earlier than I have envisaged and sap the power from the growth motor of risky assets.
 
 
 
      As for our friends at the ECB, as represented by the words of their president, I really don’t have anything to add to what I have endlessly repeated in these lines for the past 15 months.
      I really do not understand how he can assert simultaneously that:
 
·                   “interest rates are at an appropriate level (1% on the Refi)”;
·                   “I do not wish to contradict financial markets which anticipate an end to the LTROs (1 year) in December”;
·                   “We anticipate that the negative inflation rate on the eurozone (again) in October will become positive in the coming months and remain moderately positive in a horizon determinable by monetary policy”.
 
      Not only is the ECB’s inflation target of slightly under 2% way off target, since inflation has fallen into negative territory, but the stabilisation of the CPI just above 0% is just as far off. As such, we are hovering dangerously close to the red line separating us from Japanese-style deflation!
 
      Such a phenomenon, which appears much more probable for the eurozone than for the US, (apart from the flexibility question) would push the Bund-Tnotes spread to continue evolving in favour of Europe.
 
 
      I think Mr T gave the topic of the evolution credit in the eurozone short shrift, instead preferring his ritualistic admonitions to governments in the zone to bring order to their finances.
 
      To illustrate this credit problem on the eurozone, I have included, below, a graph displaying the evolution of household credit (in red) and retail sales (in white): out this morning, at -3.6% on an annual basis (-2.4% expected) and -0.7% on September (+0.2% expected). These sales have now contracted to the level of early 2005!
 
      Not only does this new plunge in the “real” economy’s activity augur poorly for our newly confident green shoot proponents, but it is also illustrates how an economy driven by credit, especially with respect to household consumption, finds itself in trouble once its motor catches the “flu”, particularly when the ECB vaccine comes way too late.
 
      During the recession of 2001-2003, the growth pace of these loans certainly slowed from 9% in 2000 to 5.50% - 6% for three years before climbing back to 10% at the height of the booms years in late 2006.
      But in the current crisis, credit has fallen at an unprecedented pace, even sinking into negative territory in recent months.
      I still do not see how, between the credit-worthy clients who do not want to borrow and the banks confronted with regulatory uncertainties as they struggle to de-leverage, that the situation is going to improve any time soon.
 
Retail sales and household loans on the eurozone
 
 
 
 
 
     In conclusion, we no longer advise positions on interest rate options, given that the weight of CTAs affect bonds futures markets to such an unbearable extent that it is no longer possible to hold macro positions for more than two days, and while the existing stock-index options benefit from minimal and variable delta negative, I prefer to leave momentum traders in peace for now..
      Better safe than sorry …
 
 
 
      Here are the links I promised you on the output gap studies (and have a good weekend!):
 
      OUTPUT GAP UNCERTAINTY: DOES IT MATTER FOR THE TAYLOR RULE? BANK FOR INTERNATIONAL SETTLEMENTS, November 1998
      Uncertainty about When the Fed Will Raise Interest Rates; Federal Reserve Bank of St. Louis, June 18, 2009
      Is the output gap showing?, Federal Reserve Bank of Atlanta, August 28, 2009
      Output Gap Measurement and Prospects in the Wake of the Crisis, Different concepts of potential GD, econbrowser, July 22, 2009
 
Disclosure : Long 20 years OAT 0% Coupons, EDF Corp 5 Years 4.5%.