It is broadly accepted that we got ourselves into this mess by allowing the banks to lend too much, too cheaply to people who were not really able to pay back the loans they shouldered.  The way out (whilst avoiding a depression caused by deflation & debt-induced personal bankruptcies) involves making existing loans servicable whilst at the same time not allowing people to add to their current debt burdens.  Hence there is a delicate tightrope to be walked along by lowering interest rates for existing borrowers but simultaneously rationing the availability of credit at the same time so that we do not dig ourselves a deeper debt hole than the one we are already in.

Credit can be rationed in two ways, either by restricting the availability of credit (via very strict lending criteria) or by raising the cost of credit (only extending new loans at high spreads over Libor or Base Rates).  Banks are currently not lending freely for many reasons which include households & corporates being unwilling to borrow, the banks wanting to make profits to rebuild their balance sheets and the knowledge that UK banks are going to have to refinance most of the maturing sterling loans which were previously extended by foreign banks (who have now all but ceased lending in the UK), amounting to roughly £80 bln annually over the next few years.

If we are ever to escape consumers having too much debt then the cost of credit needs to be kept high otherwise very low borrowing rates will simply encourage more borrowing which will prove too expensive to service when base rates eventually normalise towards the 5% level (this prospect is at least two years away).

Consumers paying down debt, however slowly, will keep the Austrian School happy as they believe the economy will never recover properly until the high debt burden is worked off.  The Bank of England may well be trying to encourage the banks to move the money they have on deposit at the BoE and lend it into the real economy but it is in no-one’s interest for this to be achieved by the banks lending at very low margins to borrowers of poor credit quality.

The upshot is that any recovery is going to be slow and protracted and banks are going to be making a lot of money during the long, slow recovery as defaults and loan loss provisions will eventually subside but banking margins will remain high as consumers will continue to be charged high rates for borrowing (personal loans, credit cards & mortgages).

The good news for the Government is that UK banks making big profits imply lots of future corporation tax revenues from the banking sector.  However, if banks make hay for long enough then eventually there will be calls for a windfall tax to be imposed on the banks “excessive profits” but that prospect is many years away (although it is hard to envisage a cash-strapped Government resisting the temptation to levy a windfall profits tax - but surely only after they have sold the UK banking shares they currently hold (LLOY, Northern Rock & RBS) at a good profit for the taxpayer).

One year on from the bankruptcy of Lehman Brothers and we have seen global stockmarkets spend six months plummeting to a low in March 2009 and then another six months rallying back again.  The Dow and S&P are now 15% below the levels at which they stood on the Friday before Lehman went bankrupt on the weekend of September 15th 2008.  The FTSE is just 5% below its close on the eve of Lehman’s bankruptcy.  We are still amidst the fog of war and nobody can quite work out whether stockmarkets are now too high following the impressive 50% rally since March or whether stockmarkets still have room to rally because an economic recovery may be starting (which then leads to an argument about whether the stockmarkets will fall again next year should there be a double-dip recession).

If we track back to the week before Lehman went bankrupt then stockmarkets had already fallen 20% from their highs in October 2007 and they were discounting some type of a recession and had not yet begun to rally in anticipation of an economic recovery.  The bankruptcy of Lehman changed the outlook so severely that markets sold off savagely to discount some type of 1930’s-style depression (with leveraged players being forced to liquidate which pushed share prices down even further).  The governments and central banks stepped in with some determined spending of taxpayers’ money and as the spectre of a depression has receded, stockmarkets have rallied back to their current levels (which are still below where they were on the eve of Lehman’s bankruptcy).

So have stockmarkets rallied too far or do they still have room to rally some more?

Although markets never move anywhere in a straight line, it feels as if they still have room to rally further as the tentative economic recovery which has begun goes on to establish itself more firmly.  Given that on the eve of Lehman’s bankruptcy markets had not yet even begun to discount an economic recovery then in order to discount whatever shape of economic recovery we are about to experience, stockmarkets should logically be higher than where they were in early September 2008.  The US and UK are likely to report positive economic growth for the quarter just ended when GDP data is reported for Q3 2009 and only time will tell whether they go on to report another quarter of growth in the final quarter of 2009 (see One Quarter at a Time).

So stockmarkets may well continue to climb the current Wall of Worry for the next couple of quarters and we can then start to consider the possibility of whether there will be a double-dip recession in 2010.  Although central banks continue to print money and interest rates will stay rooted near zero for a long while yet, a sense of normality is starting to return to corporate life with takeover activity returning to stockmarkets (Kraft/Cadbury and Balfour Beatty/Parsons Brinckerhoff being just two recent examples) and companies are finding it possible to raise equity capital (even though they are most unwilling to get deeper into debt).

Tentative it may be, but the recovery (which may well be long, slow & grinding) is only just beginning.   The fog will clear from the battlefield over the next few quarters and investors will be able to assess things more clearly.  The bad memories of the last year are still fresh in investor’s minds but stockmarkets look forwards, not backwards.

The Fed made it clear to the market with this week’s FOMC statement that speculation of a rise in the Fed Funds rate anytime soon is completely misplaced.  The Fed pointed out that with US GDP still contracting the economy has not yet even begun to work through the vast amount of slack in the system (capacity utilisation down near 65% and unemployment at 9.4%). It is this same spare capacity that means they are also not worried about the recent rise in energy & commodity prices feeding through into a sustained rise in inflation.

Even when US GDP starts to grow again (possibly later this year given that excess inventories now seem to have been worked off by manufacturers) it will take many quarters to chew through all the slack in the system (and the US economy has yet to contend with Obama raising taxes/allowing the Bush tax cuts to expire).  Therefore the FOMC “continues to anticipate that [the Fed Funds rate will stay at 0.25%] for an extended period”.

Those who think that the economy will bounce back strongly and that the Fed will soon be taking back some of its rate cuts should watch what the Fed does when it completes its $300 bln purchase of Treasuries in the autumn.  If the Fed announces it is going to spend additional money buying Treasuries then rate hikes will stay off the agenda.  Stock markets have bounced and bond yields have backed up as financial markets have regained their poise this year after the carnage inspired by Lehman’s bankruptcy last autumn.  Markets have gone from pricing in a depression to pricing in a prolonged recession and equities are currently consolidating after their sharp rally off the March 2009 lows and digesting the supply of fresh equity from corporates who are either getting their balance sheets back into shape or raising funds to take advantage of opportunities they see in the current environment (banks are not lending and credit spreads remain wide so equity is currently the default source of funding).  This is why the “green-shoot spotters” are out in force at the moment as the next move in the markets will be driven by perceptions of economic recovery or a slip back into a W-shaped recession.

For the foreseeable future the Fed continues to stimulate the economy by keeping rates close to zero and buying up Treasuries & mortgage-backed securities.  It will keep the pedal pressed firmly to the metal until the economy has grown sufficiently to have taken some of the slack out of the system.  Anyone expecting the Fed to hike rates the instant GDP starts to grow again is going to be disappointed (it is not going to repeat the 1997 Japanese mistake of raising taxes and snuffing out economic recovery the instant it has started)- a better guide to the timing of a rise in the Fed Funds rate will be given when the unemployment rate is at least two percentage points off its high and capacity utilisation is above 75% and the Fed has seen what impact any Obama tax increases have on the economy.