The Credit Crisis: Over at Last?

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The recovery in commodity prices since their nadir last December—oil is up around 50 per cent since then—has helped mining and resources shares, and surprisingly resilient retail sales have underpinned the stores. Markets such as China and India have staged exceptionally strong recoveries; the latter helped by the results of recent elections.

Equity markets seem to be convinced that the fiscal and monetary boosts administered to the world economy by the G20 have at least prevented the onset of a 1930s-style depression.

Credit markets are easing

Almost all of the standard measures of the premiums that markets demand for holding comparatively risky assets, most obviously private sector and bank debt, have eased. Banks are more willing to lend to each other and at lower rates than at the peak of the credit crunch.

The Libor/OIS spread, for example, is a barometer of how risky interbank lending is perceived to be against an effectively insured overnight index swap. At the peak of the crisis, the dollar reading peaked at about 360 basis points, or 3.6 percentage points. It has now subsided to about 65 basis points—though in normal times the spread is closer to 10 basis points.

Other credit market stress indices—such as "Teds" (which compare safe U.S. Treasury bills and interbank lending), and the iTraxx (which monitors the credit default swap market, basically the cost of insuring debts)—reveal similar trends. The credit crunch cannot be declared finally over, but this is perhaps the beginning of the end of it. The dynamics of the situation—rising consumer and business confidence feeding equity, bond and property market sentiment—are at last going in the right direction.

Glass half empty? Risks to watch for

The banks are definitely not comprehensively "fixed"—in terms of returning to normal patterns of lending. Even if they have sufficient capital on a regulatory basis, and can raise sufficient funds to pay back state shareholders, that does not mean they will now put lending ahead of preserving their capital, which is what shareholders and markets require.

Nor is the toxic assets saga entirely over: The IMF says as much as two thirds of the $4 trillion in bank write-downs are yet to be revealed. U.S. property prices are a long way off a strong recovery, which will go on undermining mortgage-backed securities.

Nor can new bank failures—with the possibility of further panic—be ruled out. Some of the emerging economies of eastern Europe are in a precarious state, many reliant on aid from the IMF. That fragility, in turn, is a continuing threat to those European banks that have large exposures to them.

More generally, in many western economies higher public debt and heavier taxation will constrain growth. Longer term, the threat is of an inflationary "double whammy"; after a lag of a year or two, the current surge in commodity prices and unprecedented monetary easing may feed through and converge to create a sharp inflationary spike, even as unemployment is rising and output barely recovered. Stagflation may yet be the abiding legacy of the credit crunch.

Provided by The Independent—from London, for Independent minds

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