Economic Perspective - Jewish Community Federation

Economic Perspective for January 25, 2008: This Is Just The Beginning
Tuesday’s surprise cut in the Federal funds rate in and of itself will
have a negligible impact on financing for the property markets.
The credit market environment won’t change until the yield curve
steepens (yields on longer term securities become much higher
than the rate on short-term paper) and steepens a lot. A low base
lending rate in combination with a steep curve is always the way
out of a market mess because it puts the necessary profit back into
fi nancial institutions so that balance sheets can be stabilized and
other financial institutions can be rescued. Once this reshuffling
of capital is effectively complete, the credit markets can get back
to the business of fi nancing economic expansion.
The yield curve, however, is still fl at and that makes recovery
problematic. Yield curves steepen when markets price to a recovery
rather than recession. To get there, broad policy intervention
must be seen as sufficient to keep the economic situation, severe
as it is, from demanding a devastating outcome. Judging from
how securities are still being priced, the consensus seems to be
that policy has yet to get out in front of a deteriorating economic
environment.
A significant factor likely weighing down market sentiment is that
the housing market cannot be particularly responsive to lower interest
rates. Housing has always been one of the main mechanisms by
which interest rate cuts stimulate the economy. This time around
we have the huge excess inventory of unsold homes, the continuing
lack of credit for marginal borrowers and the negative psychology
for house prices. These types of debt/deflation cycles are tough to
reverse and so we expect the housing market to show little nearterm
response and at best will have a delayed response.
To the point of shifting the confidence of market participants by its
actions, the Fed has also been its own worst enemy. When the Fed
comes in and cuts the funds rate in a surprise 75 basis point move,
its new transparent communication style conveys a worried Fed
rather than a pre-emptive one. When the central bank is worried,
Federal Funds Rate and its Spread to 10-Year Treasury Yields
Federal Funds Rate (%)
25
Basis Points
600
400
20
200
15
0
10
5
0
1958
1960
1962
Note: Grey bars represent recessions
Source: Federal Reserve Board
Fed Funds Target Rate
Spread to 10yr Treasury Yields
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
© 2008 Rosen Consulting Group, LLC 1
-200
-400
-600
-800
-1000

markets are frightened. At some point the central bank needs to
convey that its policy actions ensure a positive outcome rather
than that they are chasing the market to stop the fall. The Federal
funds rate will eventually be low enough to raise confidence in a
recovery and thus steepen the curve. Therefore we believe that
barring an unforeseen sudden shift in market sentiment, the funds
rate isn’t low enough.
How the low base lending rate/steep yield curve works to restart
the flow of credit is by first creating the sharply wider net interest
margins necessary to restore profit levels at financial institutions.
Financial institutions are leveraged operations and so the low
rate/steep curve sharply lowers the cost of carrying their inventory.
As bank balance sheets stabilize, investors eventually grow weary
of being “punished” for holding cash and then recommit capital to
the credit markets in order to earn compensatory returns. A less
stringent credit environment begins to unfold. This is the first sign of
a turn towards growth—an environment obviously more conducive
to real estate transactions.
The central bank has engineered a positive curve for every recovery
since 1958. This is illustrated in the accompanying chart
that compares the Federal funds rate to the spread between the
10-year Treasury yield and the target funds rate. Today’s flat yield
curve is in no way close to what is necessary to move the economy
toward recovery.
Bringing the fi nancial system to heel is, however, much more
problematic. Banks serve a unique function in the economy. They
function freely to chase profits, like any firm in any industry, but we
cannot afford to let them fail because the broader economy is then
starved of the credit necessary to grow. Whether banks will still be
given the free upside and socialized protection to the downside, a
balance that only serves to increase the risk taking, is the debate
that will take center stage once the current mess is behind us. In
the meantime, the Federal Reserve is chartered to keep the banking
system afloat and credit flowing to the economy at large, and that
is exactly what they are doing.
In sum, the required first steps have been taken but the flat curve
says that the market has yet to begin discounting a recovery in its
valuations. Until sentiment shifts to expectations for an upturn,
the credit necessary to finance economic expansion will not be
forthcoming. For the property markets, now so directly reliant on the
capital markets to insure an inflow of credit, until a steeper curve
stabilizes the debt markets, the credit crunch continues.
—Steven Blitz
A hallmark of the current expansion has been its unprecedented
reliance on cheap credit created by an intricate and overly complex
global financial system—a system that in and of itself was also
a source of economic growth. The systemic risk inherent in the
market’s unprecedented complexity means that low rates and a
steep curve will likely need to be in place for an extended period
in order to give the market the time necessary to unwind positions,
bail out participants and get balance sheets back in order. There
is some thought that the Fed needs to hold the line and allow the
free market to punish the excess and thus bring to heel what has
been an obviously out-of-control capital market—lest it risk a
resumption of cheap credit and the attendant inflation risk. The
dollar plays into this policy prescription as well, because the debt
fueled U.S. economy is doomed to implosion if foreign investors
demand signifi cantly higher real returns for their capital.
© 2008 Rosen Consulting Group, LLC 2