• Deleveraging will help determine the length and scale of the slowdown.
  In previous publications, we have discussed how the process of deleveraging has been a key driver of asset price movements over recent months. The extent to which this feeds through to tighter lending conditions will also be a critical factor in determining the shape and magnitude of the slowdown in the real economy.
• But how much has already been unwound?
  Deleveraging, though important, is also a somewhat opaque force. It isn’t possible to determine just how credit destruction will take place or even to provide a holistic measure of how much has already occurred. Here, we offer a rough answer to this question: how much of the build-up in financial market leverage over recent years has now been unwound?
• Outstanding commercial paper has returned to normal levels...
  The canary in the coalmine alerting investors to the wave of deleveraging that subsequently spread through financial markets was the rapid decline in outstanding commercial paper (CP), and especially asset-backed commercial paper (ABCP), that began in the third quarter of 2007. Until recently, however, the level of commercial paper outstanding was still above the average seen in 2001-05. This changed during September and October this year as the level of commercial paper issued by finance companies, including banks, declined rapidly. That was probably in response to the failure of Lehman Brothers, as investors became more concerned about the systemic solvency of the banking system and about governments’ willingness to support the stability of the financial system.
• ...but yields on longerdated bank paper have risen, outpacing deposit rates.
  At the same time as this capitulation of the CP market came a further leg up in the yields of bank paper traded in wholesale markets. AA-rated banks issuing in sterling are currently required to pay around 9% for 5-to-10-year funding, versus around 6.5% in mid-2007. As the yields on bank paper have risen, the average rates paid on deposits haven't kept pace. The same is true in most countries and is the result of retail deposits usually being government guaranteed up to a certain level – a benefit not enjoyed by the holders of bank paper.
• The upshot is tighter lending conditions for households.
  This change in relative funding costs is the mechanism through which the deleveraging process that started in the CP market is feeding through to the real economy. For the first time since 2002, bank deposit growth is greater than asset growth for the banking sectors of the US, the UK and the eurozone. For households and non-financial companies, this is felt through a tightening of lending conditions. In all developed economies, these are now tightening faster than during the 2001 recession.
• This has the same effect as monetary tightening and will weigh on growth for some time.
  In economic terms, this is the equivalent of a tightening of monetary conditions (via higher interest or exchange rates) and, as such, will affect activity with a lag. Hence, our central expectation is for growth to remain negative in most developed economies until mid-2009 before recovering to still well below trend rates by the year-end.
• While there is more pain to come in some sectors, we appear to have started on the road to recovery.
  That the root cause of the deleveraging move – the CP market – has returned to pre-boom levels is an encouraging sign that the deleveraging impetus may now be waning. In the meantime, some asset classes and sectors of the economy still need to respond to the deleveraging. Like the breaking of a tropical fever, however, a worsening of the symptoms is often an indication that the patient has at last started the long road to recovery.

Indices, Interest rates and Inflation

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