The dark side of falling interest rates

THE BANK of England's decision to cut interest rates last Thursday serves to remind us that we, the Americans and, in due course, the 11 countries that will be joining the European single currency in the first instance, are embarking on an interest rate-cutting cycle that has a lot further to go. Why, one may ask, should falling interest rates have a dark side and is it even necessary to ask the question?

Well, to appreciate what lies behind this, we need to understand two things. First, the world economy still faces strong deflationary headwinds. It is going to take a long time for the overhang of debt, excess capacity and insolvency to unwind. Falling interest rates soften the blow but don't really solve these problems.

Second, the world economy's current malaise was not caused by high interest rates and tight monetary conditions and it is probably rather naive to jump to the knee-jerk conclusion that falling interest rates will be the cure-all. They are essential to cushion the economic downturn ahead and to help stimulate global aggregate demand over the next couple of years. In economies such as the UK and the US with solvent banking systems and high consumer balance sheet sensitivity to interest rates, falling interest rates will be positive. But it may take longer than usual before Goldilocks comes out from behind the bushes.

The fall in interest rates so far has clearly lifted sentiment in, and flow into, equity and other risk assets and left fixed-income markets struggling. Maybe this benign state of affairs will continue through Christmas and into the new year, maybe it won't. But if financial markets are saying, in effect, that the worst of the global economic crisis is over and discounted and that the power of falling interest rates is going to work its traditional cyclical magic, I beg to differ.

I think we are seeing a W-shaped pattern of risk asset performance. Quite where we are on the first uptick is hard to say; but after the 15 to 20 per cent recovery in stock prices over the last month, a new note of caution seems warranted.

Here's why: familiar event risks; industrial country economic damage now on its way to a high street near you; and the unfolding of the downswing in the global credit cycle.

There is some better news in the familiar event risk category, but dark clouds still hover in Asia, Japan, Brazil and China. A deeper issue now for industrial countries is a bit more esoteric and lurks behind all the headlines on retail sales, unemployment and other traditional indicators. In short, it concerns the downswing in the global credit cycle and, in extremis, fears about a full-blown credit crunch - a situation where creditworthy borrowers are shut off from access to credit not because of high interest rates but because of the unwillingness of banks and credit institutions to lend.

Even if these fears are, in the end, overblown, there is sufficient cause to believe that the full impact of the credit cycle downswing has not yet been reflected in real and money GDP forecasts for 1999 and 2000. To this extent, financial markets are most unlikely yet to have discounted the downside in economic growth, earnings prospects and bond yields.

Credit market conditions are inextricably linked to real economic activity and asset prices. In its surprise interest rate cut on 15 October, the US Federal Open Market Committee stated that: "Growing caution by lenders and unsettled conditions in financial markets more generally are likely to be restraining aggregate demand in the future."

To demonstrate this, my colleague, Andy Cates, has produced some interesting work showing how the volatility and synchrony of the credit and output cycles over the last 30 years are broadly similar. This work then introduces the influence of and feedback into asset price movements. Since we are only just starting to see loose evidence of a downturn in credit growth, it is not surprising that the analysis suggests that bond yields in the US and Europe are more or less at fair value.

But with the credit cycle likely to weaken over the coming quarters, the prospect is for bond yields to trend lower, notwithstanding the recent shake-out, which has seen some investors dump bonds for stocks and credit instruments. This conclusion is supported also by the linkages between credit growth and the so-called output gap, measuring the degree of slack in the economy. The G7 countries as a whole have a small output gap, which is going to get bigger over the coming year, and which will validate lower levels of long-term interest rates before the global economy turns back up.

But with stock markets rising by about 20 per cent over the last month, a more sobering thought arises when we look at how much excess liquidity there is in relation to stock markets. The accompanying graph shows excess or deficient monetary growth, derived from an equation that relates broad monetary growth to GDP, interest rates and inflation in G7 countries and the deviation from trend in a G7 GDP-weighted equity market index. At the extreme right-hand side of the chart, the very recent turning points in both measures can be seen to have started. Looking forward, our contention is that some compression in monetary growth is likely as reduced economic activity rates, risk aversion and a weaker credit cycle interact and, in turn, take equity market values back to or below fair value.

Evidence of a weaker credit cycle is accumulating. Survey evidence in the US suggests banks are getting more cautious about loan quality and terms. More generally, the margins at which corporate and sovereign credit instruments trade over benchmark government bonds are still quite wide, despite some recent narrowing. The spread that prime Japanese banks pay for three-month interbank funds in dollars relative to prime US banks, aka the Japan premium, is now around 90 basis points and close to the historic high of last November. Last but not least, the latest CBI survey in the UK showed that the balance of firms reporting an inability to raise external finance as a constraint on investment reached its highest level (apart from one survey in 1993) since the question was asked for the first time in 1979. The evidence is still patchy - as it would be before the downturn in the economic cycle is more visible and more widespread. But the bottom line is that as the downturn gathers momentum, so the evidence will grow stronger.

The recent news that Germany's second largest bank took a $2.1bn (pounds 1.2bn) write-off on its bad loans has provided more fuel for those concerned that the credit cycle has more "nasties" in store. This write-off was in relation to real estate in eastern Germany. But the emerging market bad loan saga is not yet over. In Europe, Bank for International Settlements data show that banks (in Germany, France, Italy, UK, Spain and the Netherlands) had reported exposure to emerging markets at the end of last year of $410bn, the equivalent of nearly 6 per cent of GDP and 68 per cent of aggregate capital.

These numbers are far higher than for the US, where exposure amounted to $104bn, 1.5 per cent of GDP and 11 per cent of banks' capital. With little doubt, the US Federal Reserve can avert a credit crunch. The Europeans could too, although it is particularly unclear from the Maastricht Treaty who is supposed to do what in the event of such an outcome under a single currency. These data do not cover trading or capital market exposure, which has clearly suffered this year, nor do they include potential derivatives exposure problems.

But the point here is not to forecast a global credit crunch but rather to highlight the degree of sensitivity to monetary medicine that must first relieve symptoms before it (with other policy initiatives) can cure and restore. The overall conclusion is that interest rates do have to fall but that this is in keeping with the weakening in the credit cycle, brought about by risk aversion and balance sheet contraction, partly related to past experience and partly to the current and forthcoming economic slowdown.

The power of monetary easing is a well-known and observable phenomenon in a world where the business cycle is "normal", but most of us believe things are far from normal. Will falling interest rates work the way that is normally expected? If firms and households are trying to reduce debt, lower interest rates will not encourage them to make greater use of leverage. Since the world is characterised by over-investment, excess capacity and profit shock, lower interest rates won't necessarily encourage companies to step up to the plate and expand capital outlays. In short, the markets may be putting too much faith in the ability and speed of falling interest rates to sustain economic growth and corporate earnings in the quarters ahead.

George Magnus is chief economist at Warburg, Dillon, Read.