July 22, 2008

A week ago the mood among financial authorities here in Washington was as grim as I can recall since the present crisis broke a year ago. Bank stocks (and a bank or two) were collapsing and two massive government-backed financial institutions were fending off disaster; inflation was surging; oil prices were reaching new peaks; the dollar was touching new lows.

Compounded by an unbearable midsummer heatwave that sent humidity-adjusted temperatures above 100F, it all felt a little like a financial version of that terrible summer of 1914, a growing sense of helplessness that we were on an unavoidable collision with the guns of August.

This week, I am happy to report, the mood is a little different. Officials certainly are not out there suggesting that the worst is over. The past year has produced one too many false dawns for that level of optimism. Furthermore, the weather has not cooled enough to lighten everybody's temperament. But there is a very slightly elevated sense of temporary relief, a hope, if not yet an actual conviction, that a bullet has been dodged.

The principal cause of encouragement was a rare movement in the right direction on both the two great sources of our current woes - financial instability and oil prices.

Underpinning the fears of officials at the Treasury and the Federal Reserve a week ago was uncertainty about what the present round of quarterly reports from the big US banks would reveal about the health of the financial system.

If it became clear, as Wall Street started to report earnings in the second half of last week, that banks were failing to meet even the low expectations the market had of them, the risks of a real disaster were alarmingly real.

As it turns out, at least so far, the banks' performance has been somewhat less grim than feared. Yesterday Bank of America joined the list of bearers of “good” bad news. Its profits fell 41 per cent in the second quarter from a year earlier, but that was substantially better than analysts had forecast.

As with JPMorgan Chase, which reported similarly encouragingly bad numbers last week, the news lifted shares. Bank of America (BoA), for example, was up 50 per cent yesterday from a week ago, though that needs to be put in the brutal perspective of simple arithmetic. When your shares are down more than 66 per cent in a year, as BoA's were at one point last week, a 50 per cent increase still leaves you 50 per cent down.

Still, there is genuine good news in all this. American banks are making increasingly aggressive strides in dealing with their dead assets. This contrasts sharply with Japan's financial catastrophe of the 1990s. It was Japanese banks' failures to address the scale of their problem loans in a timely way that condemned the country to its lost decade. At this rate, the United States might be able to compress its lost decade to about three years.

There were other signs that the immediate financial danger may have passed. My favourite proxy, as I've noted before, for overall financial distress in credit markets is the TED spread - the difference between yields on eurodollar interbank loans and those on Treasury bonds. Having fallen between late April and mid-June as markets started to normalise after the collapse of Bear Stearns, the spread began to spike again in the past month.

A week ago it hit 1.45 percentage points, but has declined steadily since then. Those inclined to really giddy optimism might like to note an even more encouraging trend. The TED spread has now peaked five times in the past year - and each time the peak level has been lower than that of the previous high.

Financial sort-of-good news in the past week has been matched by similar cautious encouragement from the oil market. Oil prices fell more than 10 per cent last week. A number of explanations were advanced: easing tensions between the US and Iran; those evil speculators finally pulling in their horns. Most likely, it seems, we have, finally, reached the point where the remarkably inelastic demand for oil (price up 100 per cent in the past year, demand unchanged) has, finally, snapped. The US is using less gasoline and its economy is weak; Europe's economy is also slowing sharply. Maybe oil prices will keep falling.

A host of problems remains. If American house prices keep falling at their present rate, more bank failures and much more credit retrenchment is inevitable.

If US wages keep rising at a rate well below that of inflation, the squeeze on real demand is going to be painful, creating another round in the vicious circle of weakening economy and destabilised financial system. If the falling oil price really does reflect a sharp slowdown in global growth, our problems may be only beginning.

Above all, it is clear that the financial system is still desperately fragile and banks are still cutting back. That makes the economy much more vulnerable even to relatively small shocks than it has been for decades. For now, though, doomsday has been averted - again.

gerard.baker@thetimes.co.uk

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