Fed Rescues Wall Street

Global interest rates peak as activity begins to slow

Originally published in the October 2007 issue

  • Fears of a US house price crash and recession look exaggerated, although it is likely to be well into next year before activity returns to normal
  • As Europe's recovery begins to run out of steam, the outperformance of its equity markets comes to an end
  • Japan's slowdown deters the Bank of Japan from raising interest rates, compounding the yen's woes
  • The UK economic climate currently looks reasonably upbeat, but a housing-led downturn lies on the horizon

US interest rate cuts to underpin the economy

The Federal Reserve's more generous than expected 50 basis point cut in interest rates helped to give some relief to beleaguered Wall Street investors, but the markets are still wondering whether policymakers will be able to do enough to avert a recession. The slump in the housing market continues to get worse – work on new housing developments has fallen to a 15 year-low, and the continuing slide in the National Association of House Builders' survey of construction firms suggests housebuilding has further to fall. The news that employment shrank in August for the first time in three years has stoked fears that the slowdown is spreading. Outside the house building sector, however, firms remain surprisingly upbeat despite slower profit growth. Wider credit spreads have had only a muted impact on firms' investment plans and orders for new equipment and machinery, which continue to recover from their contraction at the end of last year.

So far, the housing downturn has had little impact on consumer spending. Mortgage equity withdrawal (MEW) – the extent to which households use value of their home as a source of cash – has evaporated after peaking at 5% of households' disposable income in 2005. But a resilient labour market – the economy has created 160,000 jobs a month, on average, for the past 18 months – has helped to offset the drag from the reversal in MEW and retail sales volumes have grown 4% over the past year, comfortably outpacing economic growth. However, it could be a different story if house prices fall more sharply. The former Federal Reserve chairman, Alan Greenspan, has said that a double-digit fall in house prices would not be a surprise. Since 2000, house prices have risen twice as quickly as the cost of renting and three times as fast as average household income, so that relative to incomes or the cost of renting, house prices look expensive.

Crucially, though, lower interest rates have helped to keep housing relatively affordable and mortgage payments on the average home still takes up only 26% of the average household's income. Although the cost of paying the mortgage is now taking up the largest share of borrowers' incomes for 15 years, mortgage payment swallowed a much higher proportion of households' incomes in the 1980s. As a result, it looks unlikely that house prices will crash, plunging the US into recession. Nevertheless, with lenders tightening standards, a large overhang of unsold properties and a pending rise in foreclosures as the low introductory rates used to entice borrowers comes to an end, the downturn in the housing market and in credit markets will remain a drag on growth well into next year.


With inflation pressures receding – core inflation has ebbed to 2.1%, its lowest in 18 months – the Federal Reserve at least ought to be able to cut interest rates sufficiently to underpin growth. Although government bonds look poor value, investors' nervousness and cooling inflation ought to allow US Treasuries to outperform other government bond markets. The interest rate outlook should help Wall Street. Moreover, US equities are discounting too much bad news and look relatively good value. Investment analysts, on balance, are also still upgrading their forecasts for US corporate profits.

The fall in the US dollar ought to boost the US market as well. In recent years, an influx of investment by foreigners in corporate bonds has helped to fund the US trade deficit – currently 6% of the US' annual economic output – and keep the dollar from falling too sharply. But the troubles in the mortgage market have discouraged investors and the dollar has found itself under renewed pressure. Moreover, with sentiment towards the currency very weak and interest rates set to fall further, the dollar is likely to have further to decline.

Slowdown keeps Bank of Japan on hold

The resignation of Japan's youngest post-war prime-minister, Shinzo Abe, after less than a year in office, and his succession by the septuagenarian Yasuo Fukuda, should not have much impact on Japan's economic outlook.

However, Mr Fakuda's conservative government is unlikely to pursue the reform agenda begun by ex-prime minister Koizumi, in whose cabinet Mr Fakuda served. The more pressing concern for investors has been the downturn in machinery orders by Japanese firms, which caused the economy to contract in the second quarter. With retail sales also weak, the economic malaise is set to remain a drag on the Japanese equity market. The Tokyo market is the only major market that is still lower than the level at which it began the year, despite the fact that Japanese banks have reported no significant exposure to the US sub-prime mortgage market.

While the current economic climate is not very promising and there remains the risk of a downturn in demand from the US, there are some better signs. In particular, export orders have begun to reaccelerate, following a slowdown at the turn of the year as weaker US demand took its toll. Export orders from the rest of the world other than the US are upbeat – particularly from the rest of Asia. Profits, too, are reasonably buoyant, suggesting the downturn in spending by firms on new equipment and premises ought to be short lived.

The news that the economy contracted in the second quarter and the turbulence in world financial markets have been sufficient to persuade the Bank of Japan to hold off from raising interest rates for now. Despite this, the Japanese yen has bounced back from its 22-year low against the currencies of Japan's main trading partners. Nevertheless, with financial markets settling down again and Japanese interest rates still exceptionally low, the currency looks set to resume its eight-year slide, particularly as the Bank of Japan is kept from raising interest rates by the soft economic climate. The strength of commodity prices also remains a heavy burden for the currency. Like short-term interest rates, 10-year government bond yields, at just under 1.7%, look low compared to markets elsewhere. As a result, Japanese bonds also appear set to underperform other government bond markets.

European recovery begins to lose steam

It would be easy to blame the recent financial market turbulence for the apparent slowdown in the euro zone, but the economic climate has been cooling for some time. The continued buoyancy of activity in Germany has helped to mask the fact that industrial activity has been decelerating across the rest of the region for a year now. Part of the reason is the doubling of interest rates to 4% over the past two years, another is the surge in the euro to a lifetime high against the US dollar, and its strongest exchange rate against the currencies of the euro zone's main trading partners in a decade.

German firms have been able to offset the impact of a stronger exchange rate by squeezing out stronger productivity gains from their workforces. As a result, Germany's effective exchange rate, taking account of productivity growth, has actually fallen 5% over the past three years despite the euro's appreciation. In contrast, weak productivity growth has meant that Italy's effective exchange rate has risen 10%, while Spain's has risen 5%. However, the euro's latest surge means that German firms have also begun to lose competitiveness and the slide in surveys of business confidence across the region reveals that the slowdown has now spread to Germany. German construction orders, the recovery in which reversed several years of decline in the aftermath of the post-reunification boom, have begun falling as well. The deteriorating economic climate, with economic indicators falling short of economists' forecasts, suggests that European stock markets will find the going increasingly difficult, although sentiment towards the region remains very positive.

Moreover, it looks unlikely that the euro will run out of steam anytime soon. Although the slowdown may deter the European Central Bank from raising interest rates one last time, the interest rate outlook continues to favour the currency, particularly now that the Federal Reserve has begun to cut interest rates. Investor sentiment is also very positive. European bond markets also look attractive, partly because yields look good value relative to markets elsewhere but also because inflation pressures remain weak and growth is cooling.

UK economy buoyant for now

Until recently, it had looked as if the Bank of England was intent on hiking interest rates at least once more, in order to stamp out any last vestige of inflationary pressures. This was despite signs that the Bank's five rate rises since July last year are beginning to have an impact on the housing market and the high street. Retailers such as Next, French Connection and Kingfisher – owner of the UK's largest home improvement chain B&Q – have all warned of tougher trading conditions

in recent weeks. According to the Royal Institute of Chartered Surveyors (RICS), enquiries to estate agents from new buyers have been falling for nine successive months. Outside London and the South East, the RICS reports that prices have begun to fall – although with financial services accounting for more than 20% of London's economic output – it is likely that the recent market turbulence will at least curtail London's boom. The near-collapse of the UK's fifth largest mortgage lender, Northern Rock, and the resulting bank run – the first in Britain for 140 years – should persuade policymakers to postpone any idea of a further rate rise, by which time it is likely to be apparent that further tightening will not be necessary.

Moreover, the fact that money-market rates are trading a full percentage point above the Bank of England's official rate, compared to a usual spread of less than 0.25%, has already put upward pressure on mortgage rates.


The Bank can at least draw some comfort from the fall in inflation below its 2% target, although higher food prices are likely to nudge prices higher in the coming months. But the Bank has yet to persuade the public that inflation has been successfully tamed. According to the Bank of England's own quarterly survey, people expect inflation to average 2.7% over the next 12 months, the highest forecast in 8 years. Policymakers will be particularly concerned that high inflation expectations push up wage demands as the critical New Year pay round nears. The Bank, therefore, is likely to disappoint hopes of an early rate cut. So, although gilts look good value compared to other government bond markets, especially now that inflation is receding, with 10-year yields already 0.75% below the Bank's official rate, they may have little room to rally further, even though sentiment is very positive.

Another reason why policymakers will be reluctant to trim interest rates is their experience in 2005, when after successfully engineering a slowdown in the housing market, they cut rates only to reignite another upturn. Moreover, while consumer spending is slowing, the manufacturers – and exporters in particular – have been enjoying their best order books for a decade, according to the Engineering Employers' Federation. For the moment, therefore, the economic climate looks relatively upbeat, particularly given the evidence that activity is cooling in continental Europe.

As a result, UK equities ought to outperform in the near-term, even if they do not look particularly good value. The current strength of activity should also benefit the pound, especially given that foreign investors have begun to favour the UK equity market. Nevertheless, the current buoyancy of activity could be short lived if the housing market downturn begins to gather pace.