By DeMasi, Jim
The tumultuous events of 2008 will be studied by economic historians for many years to come. As the year progressed, a seemingly isolated dislocation in subprime mortgages rapidly evolved into a global financial crisis and worldwide eco- nomic slowdown. Contagion from toxic se- curities backed by subprime mortgages produced a combustible mixture of delever- aging, risk repricing, flight-to-safety, and broad-based spread widening. Yield differ- entials relative to Treasuries set new records in all major sectors of the bond market at various times during the year. Losses on debt instruments became so widespread and severe that several key financial intermediaries were rescued by governmental authorities while other institutions failed. By mid-October, the credit markets were on the verge of a complete shutdown, prompting policymakers in the United States and the other industrialized nations to develop a coordinated approach for stabilizing the financial system. This multifaceted strategy contained a number of fiscal and monetary components, including injecting capital into financial institutions, guaranteeing short-term bank debt, expanding central bank lending programs, purchasing commercial paper, and buying securities issued by Fannie Mae and Freddie Mac.
Although it is still too early to judge the long- term ramifications of this unprecedented level of government intervention, the early re- turns have been decidedly mixed. On a positive note, the short-term money markets have shown notable improvement in the wake of the new government programs. Spreads have declined from their October peaks, in- terbank lending rates have fallen, and new issuance has resumed in the commercial pa- per sector. Also, 30-year fixed mortgage rates have dropped from the low 6 percent range to around 5.50 percent following the Federal Reserve's pledge to buy $600 billion in GSE debt and mortgage securities over the coming months. Despite these isolated favorable developments, overall credit conditions remained far from normal as the year drew to a close. Illiquidity continued to plague many sectors of the market, and credit spreads for corporate bonds, commercial mortgage-backed securities, and asset-backed securities remained near record highs.
During the second half of 2008, a pronounced spillover from the financial markets to the broader economy was clearly evident. The sharp decline in the value of stocks and other financial assets provided an added source of stress to consumers who were already grappling with declining home values and historically high debt burdens. The tightening of credit conditions increased borrowing costs and reduced the availability of loans for both households and businesses. The National Bureau of Economic Research officially declared that the United States had been in a recession for 12 months as of the end of November.
Economic Outlook
Developing an economic forecast for 2009 is complicated by a number of factors. First, a new administration will be taking over the White House, and the specific policies that it will pursue to address the financial market upheaval and economic downturn are not yet clear. Second, the new year likely will begin with the financial markets and broader economy still locked into a negative feedback loop. The sharp deflation in the value of financial assets during the fourth quarter of 2008 led to a dramatic, real-time decline in economic activity. As the economy faltered, the turmoil in the financial markets intensified, which led to further deterioration in the economic outlook. This adverse feedback loop has the potential to create a dangerous downward spiral and to inflict further damage on both the financial markets and the economy in 2009. Several new government programs have been created with the goal of breaking the feedback loop, but they have not yet been completely successful in disentangling the relationship. Until this objective is met, the depth and duration of the current economic slump will remain highly uncertain. Third, the problems have spread well beyond the borders of the United States, resulting in a synchronized decline in economic activity in many countries across the globe. The global economy and financial markets are far more interconnected today than during past recessions, so it is difficult to apply the principles from previous downturns to this current period of weakness.
Despite these sources of considerable uncertainty, it is fairly safe to assume that 2009 will be a highly challenging year for the U. S. economy. Softness in consumer spending will likely continue due to mounting job losses, declining equity and home prices, and tightening lending standards. Business investment should continue to struggle in light of the dwindling demand for goods and services from the household sector. The string of 12 consecutive quarterly declines in residential construction will likely be extended through 2009, as new home sales continue to languish amid high levels of existing home inventories.
Net exports, which were a source of consistent strength in 2008, will likely provide less of a positive contribution to GDP this year due to the expected weakness in global demand and renewed strength in the U.S. dollar. Taken collectively, these issues suggest that the current slump will be longer and more severe than the two most recent recessions in 1990-91 and 2001. At this point, the present economic slowdown is exhibiting similar characteristics to the more painful recessions of the 1970s and early 1980s.
Figure 1
Yield Curve Projections
While the challenges facing the U. S. economy are daunting, I believe that a replay of the 1930s is highly unlikely for several reasons. The Federal Reserve acted early and forcefully to lower interest rates and to maintain adequate liquidity in the banking system. In addition, the U. S. central bank has more than doubled the size of its balance sheet to replace some of the lending and investing capacity that has been lost in the private sector. Expect the Federal Reserve to continue to move aggressively during 2009 to lower borrowing costs and increase the supply of credit. In addition to unconventional monetary policy, a largescale fiscal stimulus program, probably in the range of $500 to $700 billion, will likely be enacted early in 2009. This program should help to offset at least a portion of the job losses expected in the private sector and to cushion the blow to GDP. Beyond the government initiatives, the significant drop in commodity prices should reduce food and energy costs, which will assist struggling households in managing their finances. However, as noted earlier, the financial markets must first stabilize before sustainable gains in the economy are likely to be achieved.
Interest Rate Outlook
Explosive growth in the money supply and record budget deficits would normally be expected to put upward pressure on interest rates. These are clearly not ordinary times, as Treasury yields have fallen to the lowest levels since the 1950s, and the effective federal funds rate traded below 0.25 percent during November. The year ended with three powerful forces dominating interest rate movements:
1. Extreme risk aversion among investors fueled a surge in demand for Treasury securities, driving rates lower across the yield curve.
2. The growing concern that the United States could enter a prolonged period of deflation caused the inflation premiums embedded in long-term government bond yields to collapse.
3. The Federal Reserve has signaled a willingness to reduce the target federal funds rate to 0 percent if necessary to prevent deflationary expectations from becoming entrenched in the economy.
For 2009, I expect the collective strength of these factors will lead to an abnormally low interest rate environment for the balance of the year.
As shown in the interest rate forecast table in Figure 1, expect rates to continue to move lower in the first half of 2009, then to stabilize in the third quarter before starting to recover by year- end as the market anticipates the potential for tighter monetary policy in 2010. Stable or declining rate scenarios would appear to have much better odds than rising rate scenarios for 2009. Consequently, community banks should continue to maintain liability- sensitive balance sheets to take advantage of what is shaping up to be a prolonged period of historically low interest rates.
Copyright America's Community Bankers Jan 2009
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