All Eyes Focused on Banking

The financial conditions in the debt markets continue improving, causing yield curves to flatten and spread to narrow further. Indeed, cash and credit default swap spreads have broadly declined in the U.S. and in Europe, driven by receding risk aversion, more confidence in financial institutions (despite additional write-downs and fairly downbeat earning projections), and modestly better-than-expected economic data. Futures markets reflect a substantial shift in sentiment too, and indicate that U.S. and European central bank rate cuts are on hold for the balance of this year (inhibited partly by stubborn inflation pressures trending above mandated targets). Most economists have concurred and have modified their policy forecasts to reflect the same.

A Welcome Climate Change

The bi-polar nature of the economy made itself known again late last week. Following weeks of dismal predictions and the prospect of an economic meltdown of cataclysmic proportions, according to former Fed Chairman Alan Greenspan, economists this week posited that perhaps the sky is not falling, according to last Wednesday’s article in the Wall Street Journal. Treasury Secretary Henry Paulson said last Friday that financial markets are “considerably calmer” now than they were two months ago and is suggesting that the economy will be rebounding by the second half of this year.

Economists are now re-thinking recession. The senior economist at Wachovia puts the prospect of a recession at 45% down from 90% in April, and Global Insight, a national forecasting firm, now believes that the government will re-adjust its assessment of GDP growth for the first quarter to a 1.2% annual rate. Even Moody’s chief economist said that recent labor market data and signs that the credit crunch is easing on Wall Street has made him “less gloomy” over the economy than he was a few months ago.

Why was there a herd mentality when it came to predicting recession? Was it because the explosive growth in GDP that we saw in early 2007 had been substantially reduced in the first quarter of 2008? Retail sales, a barometer of consumer confidence, likewise declined but remained in the positive category. In April, excluding autos, retail sales actually climbed 0.5%. Unemployment claims, which typically exceed 400,000 a week during a recession, have remained well below that watermark. What’s more, the economy is not losing jobs, which is typical of recession

It certainly is not secret that a faltering economy plays into the hands of many in the media and of politicians who can leverage bad news to sweep in change. Interestingly, billionaire George Soros, an outspoken critic of the Bush Administration and financier of Moveon.org, has argued that the U.S. economy was headed for a major crisis. Soros recently toned down his rhetoric saying that the “acute phase” of the crisis had passed.

On Friday of last week, Secretary Paulson delivered a cautiously optimistic message to business leaders saying that the economy was moving toward a rebound after months of malaise. Responding to the release of new housing data, Paulson said there will continue to be challenges, especially in housing, but “we are closer to the end of the market turmoil than the beginning.” The approximately $100 billion in stimulus payments to Americans over the next few months will certainly help fuel the economic engine.

So what’s next? Clearly there needs to be continuing pressure/stimulus from the central bank to encourage financial institutions to repair their balance sheets. At a conference this week in Chicago, Fed Chief Bernanke said he has been “encouraged” by financial institutions’ ability to raise capital and said that they need to build “generous” cushions. This, Bernanke believes, will stimulate the extension of new credit. Frankly, I believe the financial institutions can be doing more that what they have done and can resume responsible lending to power the economy, which will benefit them more than the rest of us.

Although there are numerous signs that the Fed’s aggressive actions are aiding financial institutions weather the crisis, investment banks have bid for just a fraction of the Treasury securities that the Fed auctioned in exchange for the firms’ riskier mortgage-backed debt. The latest offering drew just $7.24 billion in bids from securities firms after $25 billion was offered. Direct loans to securities firms — another Fed program launched in March — stood at $14.5 billion at the end of Wednesday, down from $16.3 billion a week earlier.

We would encourage lenders and investment banks to complete their ”spring cleaning” so they once again can get back to the business of fueling the growth of our economy, which in turn will power the world.

Lending to responsible borrowers is always good business regardless of the economic environment.

Forward Thinking

The GDP growth for the first quarter of 2008 will be revised later this week from 0.6% as reported earlier to 1.2% (hardly any sign of recession?).

Shift in Fundamentals and Policy Changes

The Federal Reserve lowered its Federal funds rate target 25 basis points to 2 percent last week, while issuing a more even-handed policy statement that provides room for the central bank to pause and allow easing to impact the economy (smart move). The Fed acknowledged that economic growth is likely to remain weak over the next few quarters. The Fed Chairman remains worried about inflation, but he expects inflation to moderate with future monetary policy changes. Importantly, the FOMC altered key language in its policy paragraph, indicating that “further ease is no longer imminent.”