Invesco Aim | Bear Necessities: Economic Terms for the Times

Credit spread — In layman’s terms, the risk difference between Treasury securities and non-Treasury securities that have the same maturity date. Investors often look at the difference between a bond’s yield versus the yield of a U.S. Treasury security with a comparable maturity as an indicator of the risk involved in owning a bond with credit risk versus owning what is generally considered a "risk-free" bond (Treasuries). Tighter/smaller credit spreads generally reflect improving economic conditions, which historically have led investors to be more comfortable with taking credit risk. In other words, investors demand less "extra" yield for taking on the credit risk associated with non-Treasuries. The opposite has held true as well: Wider/larger credit spreads generally mean investors demand more extra yield from non-Treasuries in the face of worsening economic conditions. (See yield curve.)

Deflation — A general decline in prices of goods and services across broad economic sectors, often caused by reduced money supply and/or decrease in government and consumer spending and investing. Economists consider deflation especially dangerous because businesses earn less money for each unit sold and consumers earn less money for the same work. This phenomenon makes it increasingly difficult to repay existing debts, as businesses and consumers earn less money than anticipated. As an increasing portion of income flows toward debt repayment, businesses have less money to invest and consumers have less money to spend. This decreased demand can put further downward pressure on prices and demand, creating what’s often called a "deflationary spiral." (Note that deflation is not the same as disinflation, which is the decline of the inflation rate.)

Deleverage — A company's efforts to pay off its debt. It's standard business practice for firms to borrow significant amounts of money to grow their business. If the effort fails and the business doesn't grow, however, the firm is left with little choice but to delever — or get out of debt — by paying off loans — a signal to investors that a firm is not growing.

Fiscal stimulus/stimulus packages — Generally refers to near-term government efforts geared to prevent or soften the effects of an economic recession and jumpstart economic growth via government spending and various forms of tax relief. For example, President George Bush proposed a $152 billion package in the Economic Stimulus Act of 2008, which included tax rebates, business incentives and help for homeowners facing foreclosure, among other measures. Economists’ opinions are mixed on the effects of such short-term programs.

G-20 (Group of Twenty) — Finance ministers and central bank governors of industrialized and developing economies who meet regularly to discuss key global economic issues. (Argentina, Australia, Brazil, Canada, China, European Union, France, Germany, India, Indonesia, Italy, Japan, South Korea, Mexico, Russia, Saudi Arabia, South Africa, Turkey, U.K. and the U.S.)

GDP/real GDP — The total value of all the goods and services produced within a country. Real GDP is that value adjusted for inflation and is generally used as a measure of how much a country’s economy is growing in terms of unit volume of goods and services. The U.S. GDP is published quarterly by the Department of Commerce.

Liquidity/credit crunch or crisis — An economic condition in which loans and credit suddenly become unavailable to even creditworthy borrowers, with negative results for the economy. For a simplified look at the current liquidity crisis, refer to Invesco Worldwide Fixed Income CEO Karen Dunn Kelley's article, The Credit Crisis in Four Words.

Monetary policy — The actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates. In the U.S., the Fed is in charge of the money supply.

National deficit versus national debt (also called public or government debt) — The national deficit is the difference between the government's income and its expenses in a given year, when expenses are expected to exceed income. (A surplus would be the reverse: More money is slated to come in than is budgeted to be spent). To address the shortfall, the government can issue debt of varying maturities (bonds), which are purchased by investors (creditors). The national debt is the total amount of money the government owes to creditors.

PPIP and TALF — The Public-Private Investment Program, created by the U.S. Treasury in partnership with the Federal Deposit Insurance Corporation (FDIC) and the Fed, will use $75 billion to $100 billion in TARP (see TARP) funds, along with money from private investors, to buy toxic/legacy assets (see toxic/legacy assets). One goal is to allow taxpayers to share in the upside that government funding might help produce. Initially, PPIP plans to buy $500 billion in assets, with potential to expand to $1 trillion over time. The Treasury also plans to expand the $1 trillion consumer and business lending initiative called the Term Asset-Backed Securities Loan Facility (TALF) to finance the purchase of existing mortgages and mortgage-backed securities. For more information on PPIP and TALF, refer to the U.S. Treasury website.

Quantitative easing versus credit easing — Quantitative easing refers to specific steps the government can take to increase liquidity in the economy, specifically by encouraging banks to lend money. Lowering short-term interest rates is the first step toward improving liquidity, but after rates are close to or at zero, the government has limited options, which makes quantitative easing something of a last resort. Federal Reserve Chairman Ben Bernanke refers to the U.S. version of quantitative easing as credit easing because it focuses on the mix of assets to be used to achieve the goal of increased liquidity rather than on the quantity of credit created.

Credit easing includes:

Some economists argue credit easing will put too much cash into the economy, eventually outstripping growth in the quantity of goods and services produced, which will ultimately push prices up (inflation). Others argue that without these steps, a deflationary spiral will begin (see deflation) and prolong the recession. The result of credit easing is therefore uncertain. Each dollar the Fed creates turns into multiple dollars of lending via the banking system. Borrower reticence to take out new loans amid economic uncertainty means this "multiplier" is lower than normally expected. At the same time, dampened loan demand helps keep inflation under wraps. Once loan demand picks up and the multiplier returns to more historically normal levels, the Fed will have to be very attentive to potential inflation as growth in the money supply picks up.

TARP — The Troubled Assets Relief Program was created by the government to establish and manage a Treasury fund of $700 billion. The funds were originally intended to be used by the U.S. Treasury to buy up toxic assets from financial institutions to help address the financial crisis that began in late 2007. Created with the passage of the Emergency Economic Stabilization Act of 2008, TARP was funded initially with $250 billion. The president was to certify the balance of the funds in $100 billion increments as needed and the final $350 billion; Congress was given oversight to deny the distribution of the additional amounts. In practice, much of the initial TARP funding flowed into nonvoting preferred equity shares in banks and bank holding companies. It was believed this approach would shore up bank capital and translate into increased lending ($1 of capital typically multiplies into a larger amount of lending), rather than simply replacing lending capacity dollar-for-dollar by purchasing toxic assets. The success of this application is subject to debate. It’s difficult to judge bank efforts to increase lending in an environment where economic uncertainty makes many potential borrowers unwilling to take on additional debt.

Toxic or legacy assets — The term toxic asset was coined in late 2007 to describe such financial assets as mortgage-backed securities that financial institutions could not resell because their value had significantly declined. In early 2009, the U.S. Treasury began using the term legacy assets to describe them. These assets created uncertainty about the institutions' balance sheets, which compromised their ability to raise capital and willingness to make loans. Many such assets have fallen in value for fundamental reasons as foreclosure activity has risen. Other assets continue to perform as investors anticipated but have seen market values fall due to poor market liquidity. (See PPIP.)

Trade protectionism — The policy of imposing tariffs, subsidies, import quotas and other handicaps on imports to discourage consumers from purchasing imported goods and make domestic goods look more attractive. Protectionism historically increased during periods of economic trouble, as governments seek to maintain or increase domestic economic production and jobs. Protectionism can often result in retaliatory acts by countries that buy a nation’s exported goods. This reaction can negatively affect the very economic production and jobs the initial actions sought to protect. By effectively raising consumer prices via making imported goods less attractive, protectionism may leave consumers able to afford fewer domestically produced items.

Yield curve — A line plotting interest rates, at a set point in time, of bonds of equal credit quality but different maturities, such as the three-month, two-year, five-year, 10-year and 30-year U.S. Treasuries. That yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The shape of the yield curve helps give an idea of anticipated future interest rate changes and economic activity. There are three main types of yield curve shapes: normal,when longer maturity bonds have a higher yield than shorter term bonds due to the risks associated with the time horizon; inverted, when shorter term yields are higher than longer term yields, which can be a sign of upcoming recession; and flat (or humped), when shorter and longer term yields are very close to each other, which is seen as a predictor of economic transition. The slope of the yield curve is also important: the steeper the slope, the greater the gap between short- and long-term rates. A steep yield curve can be very beneficial for banks, as they typically fund longer term investments (business and mortgage loans, for example) with shorter term funding (savings and checking accounts and CDs, for example). With a steep yield curve, there’s a wide spread between investment yields and interest rates paid on deposits.

For more information on PPIP, TARP, toxic assets and other economic terms, refer to Economic Stimulus Made Simple at invescoaim.com.

Sources: freedictionary.com/the-financial; www.G20.org; investopedia.com; www.businesspundit.com; www.treas.gov; theeconomist.com

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