TWN Info Service on Finance and Development (Mar09/01)
10 March 2009
Third World Network

Uncertainty about global downturn continues to roil markets
Published in SUNS #6652 dated 4 March 2009

Geneva, 3 Mar (Kanaga Raja) -- Financial markets continued to be turbulent over the period between end-November 2008 and 20 February 2009 due to uncertainty about the depth and duration of the global economic downturn, the Bank for International Settlements (BIS) has found.

In its latest Quarterly Review (March 2009) released on 2 March, the Basel-based bank for the central banks said that credit markets generally remained under pressure from weak economic data and earnings reports and the resulting expectations of rising defaults. Pressures were particularly evident in the renewed widening of non-investment grade spreads. Cyclical deterioration also drove the worsening of equity prices, particularly in Japan.

Uncertainties about the severity of the financial crisis and the economic downturn exerted further downward pressure on government bond yields, though mounting concerns over increased issuance limited overall declines in yield during the period under review.

At the same time, said BIS, policy measures aimed at stabilising markets appeared to gain traction over the period. In money markets, central bank actions and government guarantees helped to calm interbank markets, and spreads between Libor and overnight index swaps (OIS) continued to decline gradually.

The BIS report said that facilities that included outright purchases of agency mortgage- and other asset-backed securities contributed to signs of normalisation in mortgage markets, while funding facilities and government guarantees of financial sector issues provided a helping hand to primary debt markets, where activity surged to record levels in January.

To be sure, added BIS, policy measures backstopping debt claims on banks were generally not perceived as positive for financial shares, and financial sector concerns continued to lead overall equity market losses in the United States and Europe.

"Meanwhile, the lack of detail on key support packages, among other factors, contributed to elevated levels of implied volatility as well as to price/earnings ratios which were extremely low by the standards of the past two decades."

BIS noted that although emerging markets generally had little direct exposure to the distressed asset problem plaguing major industrial economies and managed to weather relatively well the most acute phase of the financial crisis in late 2008, they were much less immune to the deepening recession in the advanced industrial world. Plunging exports and GDP growth bore clear evidence of the severity and synchronicity of the global economic downturn, which was reflected in declining asset prices, particularly in emerging Europe.

In an overview of recent developments in financial markets, the BIS said that deeply rooted uncertainty about the global economic outlook subjected benchmark credit default swap (CDS) indices to substantial spread volatility between end-November and late February.

Having reached new highs in early December amid rising recession fears, spreads tightened into the new year, only for sentiment to turn down on weak economic data and news of further large-scale losses in the banking sector. When these developments triggered another round of policy efforts aimed at stabilising financial systems, spreads were temporarily pushed lower once again in late January, but they reverted to an upward trajectory in the course of the following month.

Given continuing problems in the banking sector, the ongoing slowdown in economic activity and constricted credit availability were likely to lead to further fundamental credit deterioration, said BIS, adding that default rates, having already increased significantly from the very low levels observed in early 2008, were thus expected to rise further, putting pressure on lower-rated issuers.

In line with these developments, risk tolerance in credit markets remained at depressed levels. Related uncertainties were also evident from implied volatilities, despite a recent retreat from the record highs established in October 2008.

As a result, said BIS, by the end of the period under review, the US five-year CDX high-yield index spread had widened by about 148 basis points from its level at end-November to near 1,534, only 38 basis points off its record high in November. Corresponding investment grade spreads, in contrast, declined by 28 basis points, to around 212. European CDS indices broadly mirrored the performance of their US counterparts, with investment grade spreads almost unchanged from their end-November levels. Japanese investment grade spreads, on the other hand, widened by 170 basis points.

One factor supporting credit markets over the period was signs that recent government measures were contributing to improved conditions in key, previously disrupted, segments of the money and credit markets. A prime example of a market experiencing tentative, policy-induced normalisation was the US mortgage sector, where agency spreads and mortgage rates continued to ease back from the highs established in October, said BIS.

The BIS report said that another sign of government-assisted normalisation came from primary debt markets, where activity surged to record levels. With a number of country authorities considering outright purchases of corporate bonds, and with guarantee programmes in place to support financial issuers, a long pipeline of pent-up issuance opened up in January.

The report however said that signs of dysfunction continued, highlighting the fragile state of market conditions and investor sentiment. The fragility was apparent, for example, in measures such as the CDS-cash basis, which reflects the pricing differential between CDS contracts and corresponding cash market bonds.

"Though not as pronounced as in the aftermath of the Lehman Brothers bankruptcy, the basis remained unusually wide in the new year, suggesting that arbitrage activities that would usually tend to compress the price differential continued to be constrained by elevated capital and financing costs for leveraged investors."

The report noted that similar effects were observed elsewhere, as evident from high and variable liquidity premia in the markets for government bonds and swaps. "Investor confidence was rattled once again when, despite a combined $925 billion of private and government capital injected into the global banking sector since the third quarter of 2007, further signs of banking problems emerged in both Europe and the United States." Those problems, added BIS, "defeated the view that large-scale government support in the third and fourth quarter of 2008 had restored the sector's stability on a sustained basis."

Events started on 8 January, when losses at a newly acquired former rival had to be backstopped by a bailout package for Commerzbank and accelerated as similar news involving other major banks aired during the following week. As a result, said BIS, credit spreads were pushed higher in shallow and volatile markets. It noted that financial sector concerns continued to weigh on spreads in the following weeks, counterbalanced in part by a new round of government support measures.

The report cited United Kingdom authorities announcing on 19 January a further broad-based rescue package for UK financial institutions, following news of large losses for 2008 at Royal Bank of Scotland. Authorities in other European countries also took additional support measures in the following days. According to BIS, those efforts, and reports of plans for a new comprehensive rescue package by the incoming US administration, helped buoy market sentiment in the period up to early February, with US and European investment grade spreads tightening back to levels last seen in November.

"However, following weak economic data and disappointment about the details of the newly announced US rescue plan, credit spreads drifted upwards once again towards late February."

In money markets, said BIS, the situation continued to improve slowly, as central bank actions and government guarantees gradually gained traction. Libor-OIS spreads, for example, edged further downwards, although by late February they were still at levels above those seen during the first year of the financial market turmoil.

Despite having started 2009 on a strong note, the BIS found that major equity markets performed poorly overall during the period under review, battered by further instances of financial sector problems and a deepening economic downturn. Between end-November 2008 and 20 February 2009, the S&P 500 index fell by 14%. Major bourses in the euro area suffered commensurate losses, while the FTSE 100 shed more than 9% during the same period.

The report said that heavy selling in financial sector shares led the way down, fuelled by revelations of outsize fourth quarter losses at financial firms on both sides of the Atlantic. "At the same time, new instances of government intervention via large-scale capital injections or outright nationalisations heightened concerns about the state of the troubled sector and the implications of increased government involvement, further hurting investors' appetite for financial sector shares."

Turning to the activity in international banking and financial markets, the BIS report said that international banking activity continued to reflect the tensions on bank balance sheets in the third quarter of 2008. BIS reporting banks' total gross international claims actually grew, by $248 billion to $37.5 trillion, driven largely by greater inter-office activity.

BIS however said that lending to other (unaffiliated) banks fell, reflecting the severe market strains following the failure of Lehman Brothers on 15 September. With interbank markets effectively shut down by end-September, banks sought dollar financing elsewhere: their liabilities to official monetary authorities soared in the third quarter, reflecting in part their use of central bank swap lines. Banks also curtailed their lending to emerging markets.

Interbank lending continued to contract in the third quarter of 2008, reflecting the ongoing tensions in interbank credit markets. On a residency basis, total claims on banks (including inter-office claims) grew by $150 billion, following the unprecedented decline of more than $800 billion in the previous quarter. However, said BIS, net of inter-office activity, lending to other (unaffiliated) banks actually fell in the third quarter as well, this time by $173 billion. The BIS consolidated banking statistics, which track banks' worldwide consolidated positions by lender nationality, suggest that reduced interbank lending by French, Belgian and German banks accounted for much of this decline.

As regards the derivatives market, the BIS report saw a continued decline of activity in the fourth quarter of 2008 on the international derivatives exchanges to the lowest levels in more than two years. Total turnover based on notional amounts decreased to $408 trillion from $543 trillion in the previous quarter. "The decline in trading activity reflects a combination of significantly reduced risk appetite, expectations of stable low interest rates in major markets and lower hedge fund activity."

Activity in equity index derivatives also saw a significant decline in the fourth quarter as markets became less volatile. Towards the end of the fourth quarter, both options and futures turnover fell sharply to $58 trillion from a historically high level of $77 trillion in the previous quarter. The significant contraction in part reflects lower hedge fund participation in these markets, said BIS.

After reaching a record of $7.9 trillion in the previous quarter, foreign exchange derivatives turnover in the fourth quarter plunged to $5.6 trillion. The decrease in activity among the main currencies was most pronounced for the US dollar and sterling, followed by the euro and yen segments.

Trading in commodity derivatives, observable only in terms of the number of contracts, increased from 411 million contracts in the third quarter to 450 million in the fourth, 10.4% higher than the same quarter in 2007.

Noting that this ended a one-year period of declining turnover, BIS said that the increase was due in part to higher turnover for non-precious metals such as copper and aluminium, most likely reflecting uncertainty about future demand. +