Interest Rates Rise: Spot the Credit Cycle?

The rise in US interest rates, echoed by tightening elsewhere in the world economy, is bad news for banking systems which:
i) show almost no sign of accelerating credit growth, and which
ii) are unlikely to be able to pass on the interest rate rises to borrowers at quite the same rate as they are obliged to raise their deposit rates.  

As a result, either banks will either have to accept lower interest rate margins, or they will protect those margins by raising the risk profile of their loanbooks. 

Anyone spotted a credit cycle?
Since the financial crisis, the economic recoveries seen in the US, the UK and now in the Eurozone have been long acyclical grinds, largely unsupported by any significant credit cycle. More, when we track the relatively small fluctuations in credit growth seen since then, most of the evidence suggests that the latest rise in interest rates is being made in economies where loan growth, and credit growth, is already slowing. 

If one takes all the bank lending of the US, Eurozone, China and Japan and expresses the total in US dollars, by February loan growth had slowed to 3.2% yoy, with the yoy rates falling almost continuously since the middle 2016, and with the 6m momentum deflecting slightly below historic seasonal trends. Moreover, comparisons are about to turn much more difficult: if current trends are maintained, yoy loan growth is likely to stop altogether by 3Q17, turning mildly negative thereafter.

Translating banks’ loan books into dollars raises as many questions as it answers. But in local currency terms, credit growth in US and China is slowing, in the Eurozone it is stable, and only in Japan can one catch sight of a genuine, if very mild, acceleration in bank lending. 

US - Credit Growth is Slowing and Will Slow Further
By February, US bank credit growth had slowed to 5.4% yoy, with the underlying momentum 1.2SDs below historic seasonal trends, the sharpest sequential slowdown since Oct 2013. Loan growth had slowed to 5% yoy, with the sequential change over the past six months, with the 1.4SDs deflection below historic seasonal trends, the sharpest slowdown since mid-2011. 

If the deflections against trend seen over the six months to February are maintained, we can expect bank lending growth to slow to just 2.5%, which would be the slowest since 2011. The outlook for total bank credit is less dramatic, with current trends suggesting growth slowing to 5.1% over the coming year. However, this implies a sharp rise in holdings of bonds and other securities, which seems counterintuitive in a rising interest-rate environment. 

This slowdown in credit growth is the result of a modest souring both in loan demand being met by a similarly modest tightening in credit criteria - with both of these being sustained for a full year now. The chart below tracks the Fed’s quarterly survey of senior loan officers: when the grey line falls below zero, it means a net tightening of credit criteria is underway. 

China - Credit Cycle Certainly Tightening
As China no longer requires the Rmb to shadow the US dollar undeviatingly, it has gained a degree of policy freedom which in theory allows it to decouple its credit conditions from those of the US. In practice, however, the relationship remains close. Currently this means that China’s credit growth is slowing both in yoy terms and, more dramatically, in its 6m deflection against 5yr trends.  

The widest accounting of China’s credit is the PBOC’s monthly domestic credit series, which shows growth of 17.1% yoy in February 2017, but with a 6m deflection of 0.6SDs below seasonalized 5yr trends. This is about the sharpest deflection below trend that we’ve seen since 2008, but is also a relatively recent development (since Nov-Dec 2016).  As a result, this is probably not a harbinger of a dramatic slowdown over the coming year, with credit growth of 16.5%-17% consistent with current trends. 

However, as with the US, this is likely to be reflecting, and to continue to reflect, strong growth in holdings of government and government-related bonds rather than loans. Bank lending growth slowed to 13% yoy in February 2017, with this total being bolstered by the authorities’  attempts to driver a greater proportion of banks’ credit activities into official bank lending (as opposed to ‘shadow banking’ products). This has allowed bank lending to sustain momentum, with the result that bank lending growth of slightly more than 12% can be expected over the coming year. 

Eurozone: Gains Against a Very Depressing Trend
At first sight the Eurozone’s credit cycle indicators look far more hopeful. Bank credit (loans and holdings of debt securities) was growing 3.9% yoy in January, of which debt securities were up 12.8% whilst total loans were up only 0.8% yoy. But as one looks closer, the impression of an ongoing credit cycle upswing dissipates, for two reasons. 

  • First, even now, core lending to the private sector is up only 1.1% yoy.
  • Second, although both total credit and lending to the private sector are growing significantly stronger than the 5yr trend (a deflection of 0.7SDs above historic seasonal trends for total credit, and 0.9SDs for private lending), the underlying trends themselves are so weak that even if they are outperformed by more than a standard deviation, we can still expect the yoy comparisons to be negative in a year’s time. If total credit growth outperforms trend by 1SD over the coming year, total credit growth will slow to just 1.1% (vs 3.9% in Jan 2017). If private sector lending outperforms trends by a full SD over the coming year, we would see loan growth falling 1.1%  yoy in Jan 2018.  

However, even this would involve a sharp acceleration in momentum from where we currently are: 6m trends vs momentum for total credit peaked in June 2016 and have slowed consistently since. Underlying 6m momentum of private sector lending peaked only in December 2016, and look very likely to continue to slow in the coming months.

In practice, we should expect yoy comparisons for total credit and for private sector lending to have already peaked, and to retreat noticeably from Feb 2017. 

Japan: A Very Modest Credit Upswing is Quietly Underway
Surprisingly enough, it is only in Japan that we can identify a genuinely positive improvement in bank lending. Bank lending rose 2.8% yoy in February, and after 18 months of deflections below 5yr trends, the underlying momentum is now mildly positive.  More, the five-year trend is now itself very modestly positive, suggesting lending growth can be expected to  3.9% - 4.1% in the coming 12m. If achieved, this will be the fastest lending growth since Japan’s bubble burst in 1990.