CNB Weekly Economic Commentary: July 12

 To: Everyone
From: Gregory S. MacKay, Senior Vice President & Chief Economist
Date: 07/09/10

We’ve talked about the moderate pace of the recovery for some time now. The cycle of jobs recovery, consumer confidence, and increased spending by both businesses and consumers has an important flash point: the creation of more credit. At the Ohio Bankers Day on June 30, Governor Elizabeth Duke gave a noteworthy address about the current credit conditions in America. With recent reports about declines in consumer spending and consumer credit, Governor Duke summarized the current credit situation in the country by discussing four factors: the banking system, the regulatory environment, financial condition of borrowers, and general economic conditions.

As to the banking system, she stated “the banking system continues to recover slowly… insured commercial banks as a group were modestly profitable during the first quarter... delinquency rates began to level off…. (but) the net charge off rate stayed near historic highs. On the positive side, capital ratios at many banks have improved substantially… strong deposit growth has contributed to steady improvement in bank liquidity… (but) lending has fallen significantly”.

Speaking about the regulatory environment, Governor Duke has heard bankers are wary of credit extensions because of upcoming changes to the regulatory and accounting standards, and concern about the stance of bank examiners “right now”. To her credit, she states “but we can and should be sure that supervisory policies do not impede the flow of credit to eligible borrowers” and highlights recent guidance issued that continues to stress “prudent and pragmatic credit and decision making” as the path for bankers to follow.

The financial condition of borrowers has two faces. As the recession advanced, some borrowers found themselves unable to meet payments, while other still credit worthy borrowers saw available credit shrinking. Governor Duke states “in response to the changes in credit… businesses and consumers stopped spending and hunkered down… (businesses) tended to pay down debt and build cash positions… the personal savings rate is far higher than it was in the years preceding the crisis”. Governor Duke believes consumer credit demand could remain “sluggish” for a while, as consumers rebuild their net worth and earnings power. Small business borrowing is headlined by two facts: (1) “a number of indicators suggest that demand for credit by small businesses is down”, (2) “we continue to hear about difficulties experienced by small business in obtaining credit”. The Fed is sufficiently concerned about credit availability to small businesses that it is holding 40 meetings across the country to assess the longer term needs of small business.

Finally, Governor Duke sees the best step the Fed can make to help credit availability is “to achieve a sustainable economic recovery”. To that end the Governor cites the accommodative monetary and liquidity policies of the Fed over the past two years, and said “as economic activity picks up… I would expect the supply of credit and the demand for credit to improve”. But the Governor ended on a cautionary note. Using the 1990-1991 recession as a comparison, she reminds us that credit growth from that recession (which had both a banking crisis and big regulatory reform) took 3-5 times longer than during other recessions.

We think Governor Duke gave an excellent summary of current conditions. Banks, in general, have the ability to lend, and are working out their loan losses. While doing so, bankers are carefully eyeing their regulators to see if any serious changes will affect their ability to do business and its profitability. At the same time all borrowers have been rebuilding their own capital, by borrowing less and seeing their net worth recover as the economy improves. The pace of credit expansion will be hampered somewhat by the size of recession and the unknowns of regulatory reform. The Fed seems to be signaling (by this speech) that low rates are here to stay well into 2011. We’re in the process of a long, slow recovery, and given current circumstances, this recovery will continue.

Equity markets are using this short week to recover from last week’s attack of the European worries. Prices have risen from month end lows as global problems eased and national economic data was at least mildly positive, but returns remain negative for the year. We’ll need some good second quarter earnings reports next week to shake off the doldrums, but we’ll probably stay in the current established trading range without unusually good news. At 1 p.m., for the week and year: 

 

Bond yields have fallen by 10-20 BPS over the past three weeks as the safety of U.S. Treasuries and the realization of lower interest rates for some time sinks in. Maintain an intermediate maturity schedule and lower your income expectations. Rates just aren’t going up for some time.