Bank lending the canary in the coal mine: former Fed economist

There is only one reliable indicator that an economy is heading for recession, and the only country where it might be flashing red is in Australia, an ex-US Federal Reserve economist says.

Markets have been thrown into a panic this year as investors struggle to interpret savage moves in prices across equity, commodity and currency markets.

Trillions of dollars in asset purchases by central banks, persistently low rates in the United States and, more ...
Trillions of dollars in asset purchases by central banks, persistently low rates in the United States and, more recently, negative interest rate experiments in Japan and Europe, have failed to revive healthy inflation. Photo: Ron Antonelli

A central worry is that spiking bank credit default spreads, ailing US corporate profits, and stress in junk bond markets are all symptoms of a global economy heading into recession.

A little known group of researchers at the US central bank in New York spent five years looking for a predictor of financial crises, and they found only one: bank lending standards.

"It's the simple idea that the cost of credit is not what suffocates an expansion, it's the availability of credit," Dr Robert Gay, managing partner at Fenwick Advisors, said at the Portfolio Construction forum on Tuesday.

"As long as you can roll over the principal at whatever price, things don't shut down," My Gay said. "Finance lubricates growth and when you stop the lubrication, you stop rolling over debt, then it becomes contagious."

There is no sign that lending standards in the US  – where banks are still lending "like wildfire" –  and Europe are heading higher, the New York-based Mr Gay, who served as a senior economist at the Fed under the chairmanship of Paul Volcker, said. 

Only Australia going up

In fact, "there is only one country where the line is going up, and that's in Australia". Of course, no indicator is perfect, but it's the best we have, Mr Gay said.

Mr Gay pointed to anecdotal evidence that banks are tightening standards in response to increased regulation, although how far lending conditions need to tighten before they start posing a substantial risk to the economy is an open question, but one regulators are sure to be asking as they attempt to hold off a potentially damaging bubble and bust in the housing market.

Mr Gay is highly critical of increasingly loose monetary policies in Europe and Japan, arguing that the ECB's quantitative easing program was "too late, too big, and too ineffectual".

"Other than that, it was fine," he joked. "QE gets old and it has diminishing returns."

The ineffectiveness of QE in Europe is why "the ECB constantly disappoints, because they can never reach their objective".

"The Bank of Japan now owns over half of the JGBs [Japanese government bonds] in the market; it looks more like a financier of governments than a central bank, hence the problem with credibility."

Nor does Mr Gay believe that negative rates are the panacea to the world's ills.

He described a meeting with the chief investment officer of a European life insurer who said she would never buy negative yielding bonds.

"She told me, 'it violates my fiduciary responsibility to policy holders',".

The issue, Mr Gay explained, is that if European life insurers – who are required to hold high quality assets, such as government bonds, to offset future liabilities – are unwilling to buy German bunds, nor will they be selling the bunds, and the ECB's transmission mechanism is stifled as policy makers won't be able to find the securities they need to buy as part of their bond-buying stimulus plan QE.

So what can policy makers do in a low-growth, low-inflation world?

Policies converging

"Not much," Mr Gay said. "People talk about 'diverging central banks' [with the US Fed tightening and others, such as central banks in Europe, Japan and China loosening], but policies are converging – five years from now we'll all be around [real rates] of zero."

The "key swing factor" is around fiscal policy, Mr Gay said, with China, US, Europe and Japan "leaning slightly towards fiscal stimulus which should give this expansion more time".

"It's the only reason to be somewhat hopeful for the year ahead."

US Fed boss Janet Yellen has been focused on removing the distortionary effects on asset prices of loose monetary policies, and the recent turmoil, where prices have fallen sharply across many markets, could provide some relief in that respect,

"She can say 'I've got what I wanted and now I can bide my time'," he said.

Mr Gay dismissed recent speculation that the US Fed would be prepared to follow central banks in Europe and Japan and push official rates below zero.

"Negative rates are inconsistent with the Fed's framework," as they threaten the profitability and therefore resilience of the banking system, he said.

In a low return environment, avoiding the losers is a key challenge for investors, Mr Gay said. He has a simple rule of thumb to pick winners and losers between countries' bonds, split neatly where net foreign assets as a percentage of GDP reaches negative 50 per cent. Above that line the default rate historically has been 1 per cent, Mr Gay explained, and that includes Argentina defaulting twice.

Below that line the chance of default rapidly rises.

Australia, "just so you know", sits at around 65 to 70 per cent, he said.

But Mr Gay said he came to realise that Australians have a different approach to assessing risk when swimming off the beach near Manly and one of his fellow swimmers spotted a marine predator.

"In the United States when somebody yells 'shark', you swim away from it," he said. "But everybody started swimming towards it and took pictures."

Mr Gay said he was also struck by a conversation with some Australians about whether they should pay down their mortgages, who explained the tax system provided an incentive for them to stay indebted and channel all their excess savings into their superannuation.  

"In a world of low growth and low inflation, the ultimate winners are those that can de-lever. The ones that cannot are going to have the problems. If you have the cash flow to de-lever, you should make every attempt to do so."

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