Business Outlook: Signs of Progress on the Road to Recovery

It's no coincidence that the recession's grip is easing now that credit conditions show every sign of loosening up. By many measures, financial markets are functioning as they were prior to September of last year, before the collapse of Lehman Brothers and American International Group (AIG). The panic following those events essentially shut down the credit markets, as investors fled any asset with risk attached, even historically safe money-market funds, for the guaranteed safety and liquidity of Treasury securities and cash. Now, an improved flow of credit is helping lay the groundwork for a recovery.

Overall financial conditions remain far from what they were when they first began to deteriorate in 2007, but recent progress has been significant. The three pillars of any smoothly functioning financial system all look stronger: The capital base of banks has improved; liquidity is much deeper; and trust in financial institutions, or more technically the willingness of investors to take on risk, is returning.

Banks are showing renewed ability to attract capital from the private sector. Since Washington's stress tests, top banks have already raised more than the $74.6 billion required by the tests, with plans to bring in even more, and 10 banks have been deemed strong enough to repay their federal aid from the Troubled Asset Relief Program. Capital is still limited by sour mortgage-related loans and assets, which continue to constrain lending, but fewer banks are tightening their lending standards.

Liquidity in the system has improved dramatically. One sign is banks' decreasing demand for short-term funding from the Federal Reserve's lending programs. The balances in five of these facilities have dropped by a combined $500 billion since the end of last year. Banks are more comfortable getting funds from each other. London Interbank Offered Rates across all maturities have fallen sharply, and the spread between the three-month LIBOR and the Fed's overnight rate, a gauge of how banks assess the riskiness of lending to one another, is down to 0.4%, near the level prior to 2007. A low cost of funds, relative to the rates at which banks lend and invest those funds, is a big plus for profitability.

Fewer worries about capital and liquidity are key reasons why investors are less averse to adding more risk in their portfolios. This shift shows up across a broad array of asset classes and markets. Most notably, stock prices have risen sharply, up 39% from their March lows, with a notable firming in bank stocks. Still, overall prices remain some 40% below their peak in October 2007.

Corporations are finding the credit markets to be a little friendlier, too. Yields on BBB-rated bonds, which are moderately risky but investment grade, have fallen from about 10% last November to below 8%. Moreover, the spread between corporate borrowing rates and safe yields on Treasury securities has narrowed greatly, indicating more desire for risk, although this spread has not yet returned to its level before the September crisis.

Some of that narrower spread also reflects rising Treasury yields. The 10-year yield has jumped to 3.9% from 2.5% in March—even after the Fed said it would begin buying $300 billion of the securities. Theories on the rise range from improving economic prospects to future inflation concerns to massive government borrowing. Clearly, the surge also reflects shifting attitudes toward risk, as demand for the safety of Treasuries wanes, pushing their prices down and yields up.

As the economy emerges from its financial nightmare, companies are beginning to show less urgency in their cost cutting. The 345,000 jobs lost in May was almost half the average decline over the previous six months. However, financial conditions and recovery prospects go hand in hand. If the economy stumbles in the second half, investors' appetite for risk will ebb, and credit will tighten up again. For now, though, the strong support from the significant improvement in market conditions is helping to keep the recovery on track.

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