TWN Info Service on Finance and Development
Weak outlook drove down asset prices, fuelled
Geneva, 19 Sep (Kanaga Raja) - Developments in financial markets during the period under review largely reflected substantial downward revisions of market participants' expectations of growth in several major economies, with prices of risky assets falling sharply in the months of July and August, the Bank for International Settlements (BIS) said on 19 September.
In its latest Quarterly Review for September 2011, the Basel-based institution, commonly viewed as the central bank for the world's central banks but in fact having some 58 members, further said that market participants' concerns about growth were amplified by perceptions that monetary and fiscal policies had only limited scope to stimulate the global economy.
According to the BIS review, the negative news
about macroeconomic conditions was compounded by concerns about euro
area sovereign debt spreading from
All of these developments led to flows into safe haven assets, with yields on 10-year US Treasuries and German bunds falling to historic lows, while gold prices and the Swiss franc soared before the Swiss National Bank imposed a floor on the Swiss currency against the euro, said BIS.
According to BIS, over the review period, global
equity prices declined by 11% on average, with larger falls in
Much of the reassessment of growth trajectories
occurred between late July and mid-August, says the review, adding that
growth-sensitive asset prices dropped particularly sharply during this
period. On 29 July, new US GDP figures showed not only that growth in
the second quarter was weaker than expected, but also that the level
of GDP was around 1% lower than previously recorded. In Europe, growth
slowed markedly in the second quarter, according to data published on
16 August, with a particularly sharp deceleration in
Furthermore, says BIS, survey-based indicators
pointed to an additional slowdown in the third quarter. For example,
purchasing manager surveys published on 1 August indicated that growth
in manufacturing activity had slowed across Asia, Europe and the
"Throughout the late July to mid-August period, some of the largest falls in equity prices occurred in countries for which survey-based indicators pointed to the sharpest third quarter growth slowdowns."
The BIS review recalled that economic growth also
appeared to be faltering in mid-2010, but growth-sensitive asset prices
did not fall as sharply then as they have in the past few months. In
mid-2010, market participants expected that additional monetary and
fiscal easing would support growth. And, those expectations turned out
to be correct, as
In contrast, the review underlines, market participants currently report that they see only limited scope for macroeconomic easing to support growth, including in some EMEs. As a result, they do not expect EMEs to drive global growth as strongly as previously.
With all of this in mind, forecasters marked down their projections of growth in several major economies for 2012 and 2013, as well as the remainder of 2011. Prices of cyclically sensitive equities fell more sharply than they did in mid-2010.
"Given that major developed economy central banks have had little or no scope for further policy interest rate cuts for some time, market participants watched for signals that authorities would engage in alternative forms of monetary stimulus. Expectations of such measures increased as some inflation pressures diminished during the review period. Many commodity prices fell, for example, leading to lower inflation expectations implied by swap contracts for some major developed economies."
Investors also reassessed the prospects for monetary
policy in the euro area and in EMEs. The ECB (European Central Bank)
raised its main policy rate by 25 basis points to 1.5% on 7 July to
help anchor inflation expectations. In response to news about weakening
economic activity, however, prices of futures on short-term interest
rates in the euro area started to decline shortly afterwards, says the
review. Some EME central banks also raised policy interest rates during
the period under review, including in
"But with expectations of inflation in the major EMEs remaining elevated, forecasters predict that short-term interest rates in these countries will stay close to current levels through to the second half of 2012 ."
According to BIS, with high and rising stocks
of government debt, market participants also reported that they perceived
less scope for advanced economies' fiscal policies to be loosened than
had been the case in mid-2010. In the euro area, IMF-EU programmes tied
some heavily indebted governments to fiscal consolidation, while others
followed the same course due to the high compensation demanded by investors
to hold their bonds. In contrast, investors were willing to finance
deficits of the
Investors then interpreted Standard & Poor's
credit rating downgrade of
"Market participants also thought that additional fiscal stimulus was unlikely to be introduced in the near term in many EMEs. Although debt stocks are in several cases lower than in advanced economies, fiscal stimulus would put upward pressure on exchange rates, which have appreciated further during the review period in a number of EMEs."
The BIS review underscores that the
The review notes that the decision of Standard & Poor's to downgrade US long-term debt did not appear to trigger mechanisms that could have led to sharp falls in the prices of US Treasury securities and other assets. Haircuts on US Treasury securities accepted in repurchase agreements, for example, did not increase to the extent of forcing borrowers to sell assets that they were no longer able to finance.
Indeed, says the review, the Depository Trust & Clearing Corporation did not change haircuts on the repurchase agreements that it clears. Similarly, US banks were not forced to liquidate assets, because federal regulators held constant the risk weight applied to securities issued or guaranteed by the US Treasury, its agencies or sponsored enterprises in determining regulatory capital ratios.
"There was little forced selling by asset managers, as mandates to hold only AAA-rated securities are very rare. Finally, few institutions were forced to find alternative collateral to support positions in other securities or derivatives."
According to BIS, the concerns over a worldwide
growth slowdown added fuel to the euro area sovereign debt crisis. A
broad-based global recovery had been viewed as an important avenue for
reducing public debt burdens. Following disappointing macroeconomic
releases from around the world, the focus turned to the question of
where the necessary growth might come from at a time when policy-makers
were running out of ammunition. With a
"Market prices reflected the concern that
the sovereign debt crisis was spreading progressively from the periphery
to the core of the euro area. Reassessments of the repayment capacities
CDS (Credit Default Swap) spreads referencing the three sovereigns rose from April to June, spiking up in July, until the euro area summit on 21 July brought them down from record levels.
The support measures announced at the summit were
at the top end of market expectations. They included a second Greek
rescue package of 109 billion euros from the European Financial Stability
Facility (EFSF) and the IMF. A relief rally reduced the two-year bond
Even though the voluntary nature of the exchange
meant, according to the International Swaps and Derivatives Association,
that it would not trigger a credit event, rating agencies interpreted
the exchange as a selective default and continued to downgrade
From July through August, notes the review, contagion
spread to the large southern European countries on concerns over growth
and the limited size of the EFSF. Perceptions that planned EFSF reforms
could prove insufficient should more countries lose access to market
funding led to a widening of Italian and Spanish yield spreads. The
rises in yields and in the cost of credit protection on government debt
began to undermine the previous belief that
Against the backdrop of growing contagion, the Euro-system reactivated its Securities Market Programme. Of particular significance, says the review, was the understanding among market participants that the intervention on 8 August involved purchases of Italian and Spanish government bonds for the first time. The scale of purchases, at 22 billion euros in the week ending 12 August, represented the largest intervention to date, albeit small relative to outstanding stocks of Italian, Spanish and peripheral sovereign bonds.
Yet market participants interpreted the intervention as an important signal that the Euro-system, which many regarded as the most credible buyer at that juncture, would bridge the gap until the EFSF was authorised to purchase debt on the secondary market in the autumn.
Over the following days, Italian and Spanish 10-year
benchmark yields declined by over 100 basis points to settle below 5%.
Actual financing costs came to 5.22% when
Given a deteriorating macroeconomic outlook, says the review, fears of contagion also left a mark on euro area core sovereign debt markets. Beginning in July, the cost of credit protection on French and German government debt increased noticeably. The 10-year spread of French over German bonds rose from 35 basis points at end-May to 89 basis points on 8 August, before falling back to around 65 basis points.
Amid disappointing revisions to growth in the core economies, the French and German leaders' joint statement on 16 August in support of the euro was met with scepticism. In the days that followed, CDS spreads soon returned to their previous levels, and the DAX and CAC equity indices declined by 7% on growth concerns.
"Market participants considered the proposed measures - which included closer coordination of economic policies, a financial transaction tax and constitutional deficit rules - as lacking in detail and as insufficient for addressing the underlying debt problems."
Investors were also disappointed that an expansion
of EFSF guarantee commitments beyond 440 billion euros and the introduction
of collectively guaranteed euro bonds had been ruled out in the joint
statement. After continued deterioration up to 6 September, markets
recorded a short-lived rebound on 7-8 September. Bond yields and CDS
spreads fell, while major European equity indices recovered 4%, when
The BIS review also found that the deterioration in sovereign creditworthiness continued to adversely affect banks' funding costs and market access. Market participants remained concerned about sovereign exposures after the European Banking Authority (EBA) published the results of its second round of bank stress tests. Market reactions on 18 July were muted, despite improvements in terms of quality, severity and cross-checking relative to last year's exercise. The EBA identified capital shortfalls in eight out of 90 major banks, and recommended capital raising for another 16 banks that had passed the test within 1 percentage point of the 5% core Tier 1 capital threshold.
According to BIS, the broad market impact of the release was limited but indicated somewhat greater differentiation across banks. CDS spreads edged up for Greek and Spanish banks, and eased for Irish and Portuguese banks. Analysts focussed on the disclosures of sovereign exposures accompanying the official results to run their own sovereign default scenarios. In most cases, these suggested that market-implied haircuts on peripheral European debt would cut capital ratios, but to manageable levels.
However, notes the review, fears that serious
debt strains would spill over to
Bank equity valuations plunged as asset managers reportedly lowered their overall allocations to bank equity as an asset class. This caused bank equity to sharply underperform an already declining broader market, and drove up CDS spreads across the banking industry.
"By early September, bank valuations had
tested new depths on both sides of the
These developments went hand in hand with tensions in bank funding markets. The senior unsecured term funding segment had been difficult to access for some time, but issuance declined further in July and August. Euro area banks' bond issuance fell sharply, to $20 billion in July, along with a shortening of maturities. Many European banks faced difficulties in raising long-term funding in the past few months, and market participants became increasingly concerned about prohibitive pricing.
According to the review, in the absence of market funding, banks headquartered in countries associated with sovereign debt problems continued to rely on Euro-system liquidity to fund a significant share of their balance sheet. For Greek banks, central bank funding accounted for 96 billion euros (end-July) plus emergency liquidity; for Irish and Portuguese banks, the corresponding figures were 98 billion euros and 46 billion euros (August), respectively.
Industry research indicates that most large European banks have already funded some 90% of their 2011 term funding targets and even pre-funded for 2012, notes BIS.
"Bank funding spreads rose noticeably in August, but remained far below the levels reached in the aftermath of the Lehman Brothers bankruptcy. Some signs suggested that banks had grown more reluctant to lend to each other and had placed funds at the central bank instead."
At the same time, signs of renewed US dollar funding pressures resurfaced. FX (foreign exchange) swap spreads, which represent the premium paid by financial institutions for swapping euros into dollars, jumped to 92 basis points at a time when US money market mutual funds were reducing their exposure to European bank debt.
Estimates of US dollar funding gaps among European banks suggest that funding needs remained sizeable, although they have come down substantially from their 2007-08 peaks, says the review.
The review also found that fears of recession
in some mature economies and serious strains in the euro area sovereign
bond markets increased the demand for traditional safe haven assets.
As a result, yields on some of the most highly rated and liquid sovereign
bonds fell markedly during the period under review. Ten-year yields
on US, German and Swiss government debt fell below 2%, while real interest
rates on long-term US and
Nominal yields on some short-dated US Treasury bills even fell below zero in early August, although this coincided with Bank of New York Mellon's announcement that it would begin charging fees on large deposits. Also, the price of gold set new historic records and the Swiss franc appreciated sharply as investors moved into Swiss assets. These included Swiss government bonds, which had negative yields out to two-year maturities for much of August.
According to BIS, the Swiss National Bank (SNB) reacted strongly to the appreciation of its currency. On 3 August, the SNB announced that it would cut its target interest rate to "as close to zero as possible". It also boosted the amount that it lends in the interbank market from CHF 30 billion to CHF 200 billion, reducing interbank borrowing rates at all maturities. This contributed to a decline in the value of the Swiss franc of over 10% against the euro.
It began to appreciate again at the beginning of September, however, prompting the SNB to state on 6 September that: "With immediate effect, it will no longer tolerate a EUR/CHF exchange rate below the minimum rate of CHF 1.20. The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities."
The review notes that other countries also introduced
measures to counter upward pressure on the value of their currencies.
And the Brazilian government introduced on 27 July a 1% transaction tax on onshore foreign exchange derivatives trades that result in US dollar short positions over $10 million. Since then, the Brazilian real has depreciated by around 5% against the dollar, the review adds.