Even as European policymakers discussed the high level of economic uncertainty stemming from the financial crisis, the focus remains on the impact of the $700bn US financial rescue package, which has been approved by the US Senate and House of Representatives following the rejection of an earlier version. Proponents of the bill cited the record 778-point drop in the Dow following the House’s rejection of the legislation as evidence of the urgency to stabilise the banking system.

Our surveyed economists slashed their economic outlook before Friday's weaker than expected payroll report. “Our G3 economic forecast has very quickly morphed into a mild recession,” says David Hensley, economist at JP Morgan. “Euro area GDP is now forecast to fall to a 1% annual rate in Q3 and Q4. The ECB is expected to join the Fed in cutting rates by year end, with the refinance rate eventually falling to 2.75%.” JP Morgan expects the ECB to lower its benchmark rate by 25bp at the end of December, while betting on a 50bp reduction by the Federal Reserve. The slowdown in economic activity reflects, in part, the cost of rising borrowing costs for companies: with credit markets remaining tight, many companies will have to draw down their reserves. Eventually, companies’ inability to borrow would directly impact the financing of ongoing operations and investment.

TED spread ignores the Fed

Global credit markets remained choked in the aftermath of the Senate vote on the US bailout plan. One market metric used to measure the credit crisis is the TED spread. It measures the difference between the yield on three-month US Treasury bills and the three-month London inter-bank offered rate (LIBOR). “This credit crisis only ends when this spread returns to its normal level of about 30bps,” says David Rosenberg, North American economist at Merrill Lynch. “When you think about it, the narrowest it ever got during the credit crunch was 75bps.” On Thursday, October 2, the spread was 270bps, with three-month Treasuries yielding 59bps, beneficiaries of flight-to-quality. It appears that the injection of billions of dollars by central banks ($30bn was offered to banks in an overnight operation by the ECB earlier in the week) has done little to increase the willingness of banks to lend to one another. They have opted to hoard cash instead. Merrill cites the heightened credit crisis as one factor in lowering its base rate forecast for December by 25bp in line with consensus. Yet Rosenberg has been sounding recession alarms since the start of 2008.

Another confirmation of recession fears came this week in the form of a sharp contraction in US manufacturing activity. The Institute for Supply Management released October 1 a September reading of 43.5, the lowest level since 2001. The reading dropped from 49.9 in August, the largest one-month decline since January 1984. Economists had predicted a much stronger reading of 49.5. Prior to the drop, the index had been hovering on what economists call the boom-bust line of 50 for most of the year.

The US consumer seems tapped out too. In the past, when markets faltered, American consumers have come to the rescue of businesses, continuing to borrow. With property values falling and tighter sources of credit, Americans will learn to save again, notes Rosenberg. The savings rate jumped to 2.5% in August. His prediction: savings, over time will head to 8%, back to Reagan-era levels. With the dampened US economic outlook extending to Europe, one beneficiary continues to be the US dollar. The consensus median forecast for the euro/dollar stands at 1.37 in 2009 compared to 1.40 in September.

VB

 Consensus October 2008