'Extending' QE In The UK & Output Gaps

The prospect of a cut in deposit rates on UK bank reserves marks a hardening of ‘quantitative easing’. The Bank of England has led the way on unconventional monetary policy and its moreproactive stance is paying dividends. The RICS survey was not universally strong, but therewere enough positive indicators to suggest the UK is emerging from the credit crunch in better shape than either the US or Euroland. Inflation is not falling quite as quickly as anticipated. Indeed, the acceleration in core goods inflation is eye-catching and points to a notable shiftin inflation dynamics. Low wages will keep service inflation suppressed, but overall, it is hardto see the UK needing QE much beyond the first half of 2010. There are, however, three risks:fiscal retrenchment may need to be more severe than even the Conservatives claim. The external backdrop, such an important driver for financial services, is far from reassuring. That combined with the huge drop in economic activity during the months following the collapse ofLehman Brothers suggests it will take sometime before the output gap is closed. Mr King clearly concurs.

UK Leading Policy

It may appear odd to suggest the UK is leading the ‘recovery’. The 0.7% q/q contraction inGDP during Q2 seemed to confirm thatextreme debt levels and an over-dependency on financial services had made the UK more vulnerable than any other industrialised economy, with the possible exception of Japan. Butthe contraction in domestic demand for the UK of 0.9% q/q was only marginally worse than Euroland, which showed a drop of 0.8% q/q. And the PMIs show the UK is bouncing back fromthe Q2 contraction. Statistically, the UK is out of recession.
Some credit the BoE’s announcement on QE in March as an important trigger for the UK’srecovery. It certainly set the stage for a swift fall in corporate bond yields. The average yieldon non-investment grade bonds reached peaked a month after the £75bn Asset PurchaseProgramme was unveiled, and has since more than halved. But the UK is hardly alone. Indeed, while allowances need to be made for variations in composition, the average borrowing costsfor High Yield companies has fallen more in the US and Euroland. The big contrast has beenthe transmission mechanism of monetary policy, property supply and in the case of the US, timing. A greater reliance on short term funding has been critical in allowing the BoE to support the housing market. Ironically, the Fed was the one central bank that needed to embraceQE, because of its greater dependency on 30-year fixed rate mortgages. But it did not announce a programme of Treasury purchases until after the BoE. Even then, QE was limited in comparison. The Fed chose instead credit easing, which had some benefit. But once the long delayin relation to the peak of house prices was taken into account - the property market startedturning down in the US two years before the UK - the Fed’s actions pale in comparison.
FOMC officials might point to a bounce in the S&P/Case Shiller as evidence of a similar recovery to that seen in the UK. But it is impossible to judge how far prices are being supported bythe tax rebate introduced in the spring. The US is afflicted by much higher rates of delinquencies, foreclosures and repossessions. The extent to which sales are being driven by foreclosed properties should not be overlooked either.
By contrast, the recent improvement in the UK housing market has more secure foundations.
The latest RICS survey provides some evidence of a pick-up in supply, but overall, inventories remain historically low. Surveyors reported an average of 63.3 homes on their books in August,compared with a peak of 90.4 in February 2008. Sales are heading up and prices continue tofirm, although there was a drop in new buyer enquiries. Nevertheless, the latest DCLG index for July showed the 6-month annualised rate, based on s.a. data, has risen from a low of 16.8%in March to -0.8%, an impressive turnaround. Anecdotal evidence of competitive pressures returning to the mortgage market suggests approvals are likely to head higher, albeit from still relatively depressed levels.
The improved short term outlook for the UK economy was given some support by today’s labour market data, although it also contained a warning of the longer term risks. The rise in unemployment on the ILO measure has slowed, from a peak of 281k to 201k (3m/3m). But average earnings growth slumped again on both a headline basis from 1.8% y/y to 1.1% y/y and excluding bonuses, dropped from 2.2% y/y to1.8% y/y. Private sector earnings were up just1.4% y/y, with both manufacturing and services posting significant decelerations. But there was a sizeable dip in public sector earnings too, from 4.0% y/y to 3.0% y/y.
This may in part explain Mr King’s dovish comments yesterday, even though the wider core inflation rate stubbornly refuses to fall.Sterling’s devaluation in 2008 is clearly leaving its mark on the CPI, as core goods inflation rose to 0.3% in August, its highest level sinceMarch 1997. But that was offset by a further drop in services inflation, from 3.1% to 2.9%.While half of that was related to airline fares, the strong correlation with average earnings suggests service inflation will continue to trend lower. However, Mervyn King’s willingness to consider more extreme steps is not guided by short term inflation trends. It is the emergence of asizeable negative output gap that is driving policy. To reiterate, he warned that “growth ratesdon’t tell the story. It is the levels that really matter.” And he added, the recession “will continue even if we get a small positive growth rate over the next few quarters”.

This was important testimony. The difference between economic charts using absolute dataand rates of change is vast for many indicators at this juncture. Rates of change should not beignored. The 3m/3m rates can provide an early warning of a rapid recovery. But equally, if many of these rates of change merely return to positive territory, it may not be enough, becauseoutput fell so much more than many expected in the months after Lehman Brothers failed. Theoutput gap remains, therefore, the defining yardstick. Some suggest it is not measurable. But unemployment is one indicator of excess ‘capacity’ within an economy. The gap between output and the recent cyclical peak is another obvious guide. In the UK, the gap is smaller than in the US or Euroland, based on manufacturing production (13.3% versus 16.4% and 20.6% in the USand UK respectively). And yet, Mr King is clearly not inclined to raise interest rates justbecause the economy may be expanding again.

Whether any move to cut the deposit rate on bank reserves would really make that much difference, is open to debate. A drop in rates to zero in Japan led to a collapse in money parked by banks in the call market, and a decline in reserves. But it did not lead to a recovery in banklending. On balance, it is a worthwhile policy tool, but its effect may be marginal. The key is a stabilisation of property values by acting quickly in the early stages of the downturn.

Solvency Risks For The FHA And Payrolls

The stock market managed to end the week on a firm footing, overlooking a poor payroll report.Indeed, the Dow Jones is close to making new highs for the year. Job cuts may be good for corporate earnings in the short run, but not in the long run. With nowhere to go on short terminterest rates, and QE constrained by domestic and international political opposition (seewww.telegraph.co.uk/finance/economics/6146957/China-alarmed-by-US-money-printing.html), persistent job losses could yet derail the recovery. There was some good news last week: chain store sales were better than expected. But the economy needs to recover swiftly to prevent further job losses pushing the delinquency rate and foreclosures higher. Furthermore, on theanniversary of Fannie Mae’s and Freddie Mac’s nationalisation, it is perhaps ironic that theFederal Housing Administration (FHA) is now facing a solvency crisis. It has been the stop-gapfor mortgage funding in recent quarters. But the FHA’s travails show that ‘easy lending’ is not the answer to a debt crisis. The persistent job losses and the sluggish nature of any recovery suggest the cycle of debt deflation remains far from broken. It also highlights the risks of a relapse in 2010.

FHA, The Stop-Gap

It is one year since Fannie Mae and Freddie Mac were nationalised. This was supposed to mark the end of the US housing crisis, but twelve months later, foreclosures are still rising. Full figures for August are not yet available from RealtyTrac, but anecdotal evidence suggests the recent trend towards new highsremains intact (see www.charlotteobserver.com/597/story/925955.html?storylink=omni_popular). Obama administration officials have followed the Bush strategy of using any tools at their disposal to extend the profligate lending policies of the boom years as it tries desperately tosupport the housing market. If the Federal Housing Administration had not been let off its leash, there is no doubt that mortgage applications would have fallen even further. The FHA’sloans outstanding totalled US$429bn in FY2008, and that is expected to rise to US$627bn this year. The FHA’s market share reached 23.0% in the second quarter of 2009, compared with just 2.7% in 2006.
But using the FHA as a stop-gap has spawned a new set of problems for the US administration. The recent MBA report provided a clear insight into the deterioration of the FHA’s portfolio, which far exceeds the decline in the overall numbers as compiled in the National Delinquency Survey. Across all loans, the proportion of borrowers delinquent rose to 9.24% in Q2, up from 9.12% in Q1. For the FHA, the delinquency rate climbed from 13.84% to 14.42% a bigger increase from a higher level a priori. The seriously delinquent rate (90 days plus) wassignificantly higher - 5.24% for FHA loans in Q2, up from 4.73% in Q1. That compares with a rise from 3.57% to 3.98% across all loans. The FHA’s delinquency rate for ARMs in particular is climbing sharply, having jumped from 17.36% in Q1 to 18.04% in Q2.

It is worth noting that the delinquent rate across FHA loans has been consistently high for some years. It never really fell after the dotcom recession and, of course, has since risen to afresh peak. The overall delinquency rate fell to a low of 4.31% in Q1 2005, during the long housing boom that followed the cut in the Fed funds target to 1.0%. But the FHA delinquency ratewas still 11.73% at this point. There has for some time been a strong, vociferous campaign byopponents of the FHA, who have argued that its lending policies and underwriting standards
have been ‘out of control’. There is clearly hard data to substantiate these criticisms. So long as the FHA had a comparatively smaller share of the lending pie, these higher delinquency
rates were less significant. However, now the FHA dominates the market, it is having a material impact on the overall numbers.

Nevertheless, it is not having a distorting impact on foreclosures. The foreclosure started rate across all loans rose from 1.34% in Q1 to 1.47% in Q2. For the FHA, the foreclosure started rate rose from 1.01% to 1.22%. The number of borrowers in foreclosure is reported in non-seasonally adjusted terms, and it climbed from 3.86% to 4.43% across all loans between Q1 and Q2.That compares with an increase from 2.76% to 2.98% for FHA loans. Adjusting for seasonalities shows a rise to 4.43% (all loans) and 3.06% (FHA) in Q2. This gap in the foreclosure ratesis again evidence of lacklustre standards at the FHA. It has a higher delinquency rate by some margin, but a lower foreclosure rate on both counts - started and inventory.

However, even with this comparatively low foreclosure rate, the FHA is still in danger of falling below the required reserve threshold of 2%. Whether Congress simply agrees to another taxpayer funded bailout and allows the FHA to carry on fulfilling its role as a vital prop for thehousing market, remains to be seen. But it does highlight an unsatisfactory aspect of the USadministrations’ response to the housing crisis. Indeed, the FHA’s plight is symptomatic of aflaw at the heart of US policy. Artificial support that relies on easy lending invites further trouble down the line. But it also deflects from the urgent action needed to prevent existing borrowers turning delinquent. The correct solution from the outset would surely have been to drive borrowing costs down more aggressively through a more comprehensive programme ofQE, combined with a tighter fiscal policy. A bailout for the FHA will simply add to the pressures on government finances and will inturn keep bond yields elevated. It will also aggravate foreign investors concerns that theUS may eventually default on some of its obligations, thus adding to the pressure forhigher Treasury yields.

The stock market seems blissfully unperturbed, managing to cast aside another risein the jobless rate on Friday to 9.7% that canonly threaten higher delinquencies in thecoming months. The drop in non-farmemployment (211k) may have been the lowestsince last August. But the payroll data is diverging somewhat from the jobless claims. It hasto be said, initial claims are not always ahead of payrolls (see chart). Indeed, claims have been lagging during the current cycle. But the current 4 week average for claims, 571.3k, is certainlynot consistent with the 211k drop in payrolls seen in August. Claims will have to fall sharplyin the coming months, or payrolls may yet be revised to show bigger losses.

There was one piece of good news last week. The decline in chain store sales narrowed from5.1% y/y to 2.0% y/y in August. There is an outside chance that consumption will add modestly to growth in Q3, with vehicle sales also rising. But it should be stressed: real consumption excluding autos fell 0.4% during the five months to July. Any increase in August could still leave the 6-month rate trailing in negative territory. The Obama administration might haveexpected a better return from a seismic loosening of fiscal and monetary policy, and from sucha dramatic relaxation of underwriting standards at the FHA.

The Obama 'Honeymoon'/The King Speaks

When the stock market was tumbling towards the end of November last year, there was concern that the Dow Jones Industrials would break its long term support line stretching back to 1990. After a respite lasting barely two months, we are now in danger of re-testing that support line, as financials continue their long slide. It is tempting to view this simply through the prism of relentless losses being announced by banks. But the underlying cause is a failure of the FOMC to get ahead of the curve, and their continuing prevarication over quantitative easing (QE). As we warned last Wednesday, Mr Bernanke missed a major opportunity when he spoke in London last week. Only the announcement of aggressive and immediate buying of Treasuries can give us any hope of averting a significant unravelling of the 1990’s bull market.

Prevarication is the correct label for the Bank of England too. Mervyn King’s elaboration of QE last night contained a number of critical misapprehensions, and there was no sense of urgency either. With stock markets threatening to lurch down, it is not good enough to suggest that “at some point, the MPC might wish to adopt these unconventional measures as an instrument of policy”. Unemployment is accelerating upwards and corporate borrowing costs remain close to record highs. The BoE should be buying gilts now, and not just focusing on high quality corporate bonds.

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