BoE: How Much, How Soon?

- With money markets still in a state of gridlock, despite some easing in financial tensions, the spread of the key 3-month libor rate over the Bank rate remains historically elevated. We believe the monetary transmission mechanism is impaired,  likely lengthening the lags with which monetary policy will act on the real economy.

For this reason, we believe the MPC should lower the Bank rate substantially over the coming months in order to prevent a deep and prolonged recession. We look for the MPC to slash the Bank rate by 100bps, to 3.5%, on Thursday and continue to look for a 2.0% trough by 2Q 2009.

Financial market healing since early October has been modest and libor spreads over central bank rates still remain elevated. However, signs of life have returned to money and commercial paper markets. For instance, the 3-month dollar libor spread over the funds rate has fallen by half since its early October peak, to around 200bps. Less dramatic—but still noticeable—declines have been recorded in euro and sterling money markets.

While aggressive rate easing by the BoE remains one of the most important mechanisms to support the faltering economy, we still see worrying signs that the monetary transmission mechanism has become impaired. In the main, this is reflected by the still very elevated libor spreads over central bank rates. This is also highlighted by the only partial pass-through of the BoE’s cumulative 125bps of easing since December 2007. Popular two-year tracker and fixed mortgage rates—latest data is to September and, therefore, do not account for the emergency 50bp cut on October 8th—are currently at the same level as prior to the onset of the financial market crisis in mid-2007, despite the 75bp of cumulative easing to April this year and markets pricing in a considerable amount of easing from the BoE in coming months.

While we expect that the government’s recapitalisation package to support the banking system will lead to further improvement in the financial system, this is likely to take considerable time. Meanwhile, signs that the global economy is flirting with recession will place additional pressure on the banking system at a time when it is least able to deal with a serious downturn in the ‘traditional’ credit cycle, with repossessions and loan failure likely to accelerate sharply. For this reason, it is likely that the usual lags with which monetary policy changes impact the real economy will be even longer in the present circumstance—possibly up to 12 months from the standard 6-9 months in benign conditions.

A plunge in net mortgage lending since mid-July last year has been the most dramatic evidence of a ‘credit crunch’ for UK households. Data last week did reveal that net mortgage lending bounced up by £2.2bn in September. However, this was from a recorded fall of £0.7bn the month before— the first decline, and an all-time low, since the series began in 1993—which indicated that, in August, households repaid more on their mortgages than they borrowed.

The effect of the slump in net secured lending from a monthly average of £9.5bn prior to the start of the financial crisis last year to £2.2bn now has been a sharp slowdown in the growth of total outstanding secured lending. Having peaked at 15% yoy in 2004, the growth in value of outstanding mortgages has decelerated sharply to 5.0% in September 2008. The BoE data also showed that mortgage approvals ticked up to 33k in September from 32k. Although marginal, this was the first increase since June 2007. However, approvals remain 67% lower than a year ago and there are few signs yet that the housing market has bottomed. Indeed, house prices fell a further 1.4% mom in October, according to the Nationwide. Since the peak in October last year, this index of house prices has now fallen by 14.6%, making the present correction already slightly greater than the peak-to-trough drop in the early 1990s’ housing market bust.

The more notable feature of the BoE lending data for September was the fall in new consumer credit to £0.3bn from £1.1bn, the weakest monthly amount since February 1994. By contrast, in the year to June 2008, net consumer credit averaged £1.2bn per month. The sharp weakening in consumer credit supports an already wide array of data that suggest that consumer spending is set to slow significantly in coming months, in our view.

Consumer sentiment fell back to –36 in October, having risen off a 30-year low of – 39 in the prior two months. News of coordinated central bank rate cuts to stave off global recession and the widely reported government bailout packages for the banking system were likely responsible for the renewed deterioration in sentiment. Notably, expectations for consumer prices over the coming 12 months slumped, plunging to an almost two-year low of +65 from +82 in September.

Meanwhile, expectations for unemployment in the coming year jumped to the highest level since at least February 1996, at +61, from +53 in September. Ominously, for retailers, the index reflecting households’ willingness to undertake a major purchase today fell to a fresh all-time low of –43 in October from –32, the biggest monthly decline since late 2003.

From the retailers’ perspective, the outlook remains challenging, to say the least. The CBI’s distributive trades survey on the retail sector revealed that reported sales balance was unchanged in October at –27, the fourth-weakest reading in the survey’s 25-year history—the worst two readings came in July and August of this year. As the unemployment rate likely soars to 8% over the coming year from the current 5.7% level, adding around 800k to the numbers of unemployed, we expect to see a sharp retrenchment in consumer spending, which is likely to slump by 1.4% next year, in our view, dragging down overall GDP by 1.2%.

Amid signs of a significant retrenchment in consumer spending just around the corner and with the impairment of the monetary transmission mechanism implying longer-that-usual policy lags, we believe the MPC should lower the Bank rate substantially over the coming months, in order to prevent a deep and prolonged recession. We look for the MPC to slash the Bank rate by 100bp, to 3.50%, on Thursday and continue to expect the Bank rate will fall to 2.0% by 2Q 2009.

source: Bank of America