TWN Info Service on Finance and Development (June12/04)
14 June 2012
Third World Network

Euro area concerns drove up market volatility, says BIS
Published in SUNS #7385 dated 8 June 2012

Geneva, 7 Jun (Kanaga Raja) -- Over the past three months, financial market participants have shifted their attention from hopes of global economic recovery to concerns about Europe, particularly over euro area economic growth, the financial health of sovereigns and banks in the euro area, the impact of fiscal consolidation on growth, and political stability inside the euro area.

This is the assessment of the Bank for International Settlements (BIS) in its latest quarterly review released this week.

"All of this, combined with early signs of more fragile US and Chinese growth, made investors more cautious and drove up financial market volatility," the Basel-based central bank said.

According to the quarterly review, hopes for the global economic recovery and concerns about the euro area were the two main competing themes in the marketplace in the period from March to May. These two themes interacted throughout and were broadly reflected across financial markets.

Early in the period, said BIS, following the European Central Bank's (ECB) longer-term refinancing operations, investor sentiment improved substantially. With bank funding strains reduced, the focus shifted to the strength of the global economy. Positive US economic news and the continued resilience of emerging market growth helped raise hopes of a steady economic recovery.

The renewed optimism was particularly visible in equity and commodity markets. Fixed income markets saw a compression in credit spreads, especially for banks and selected euro area sovereigns. It also resulted in a spurt of capital inflows to emerging markets.

But by the middle of May, doubts had returned: doubts about euro area growth; doubts about the financial health of euro area sovereigns; doubts about banks; doubts about the impact of fiscal consolidation on growth; and finally, doubts about political stability inside the euro area, BIS added.

According to BIS, the ECB's special longer-term refinancing operations (LTROs) successfully reduced the perceived risk of a severe banking crisis in Europe. By early March, the scale of the combined liquidity injection in the two operations had produced a noticeable impact across financial markets. Concerns about severe downside risks of market participants faded and investors' risk appetite generally picked up.

The temporary improvement in risk sentiment was also clearly reflected in the implied volatility of equity options. After having been elevated during the latter part of 2011, the VIX reached its lowest level since June 2007.

Funding conditions for euro area banks improved significantly as they benefited from the second installment of the ECB's longer-term operations on 29 February. With a take-up of 530 billion euros for three years at the average policy rate over the duration of the loans (currently 1%), the LTRO funds helped financial institutions with funding difficulties cover maturing debt. As risk perceptions eased, European and US bank credit spreads fell, at least temporarily, said BIS.

The successful easing of funding stress was highly visible in money markets, where Libor-OIS spreads tightened by around 60 basis points in the euro market and by around 20 basis points in the US dollar market, BIS noted, adding that the improvement was also visible in the primary market for long-term unsecured bank bonds, which reopened temporarily at the beginning of the year.

The overall benign market conditions in March also helped ensure a smooth completion of the 200 billion euros Greek debt swap. This took place in the second week of March with very limited impact on other European sovereign bond and credit default swap (CDS) markets. The debt swap triggered payouts on a moderate amount of outstanding CDS written on Greek government bonds. These were settled without difficulty, thus removing earlier investor concerns about the ineffectiveness of hedging sovereign risk via CDS contracts.

"The spurt of euro area optimism driven by policy actions and growth expectations provided temporary relief for policymakers and investors concerned about the outlook for euro area sovereigns. Yields on both Spanish and Italian government bonds declined significantly," stressed BIS.

As euro area strains eased, market participants focused on the global growth outlook. Positive news about the US economic recovery led market participants to revise upwards their US growth expectations.

According to BIS, labour market figures for the US economy, partly reflecting benign weather conditions, also showed signs of improvement. Output growth in Japan recovered moderately, owing to post-earthquake reconstruction. The resilience of growth in major emerging economies (particularly in Asia) likewise supported a more optimistic outlook for the global economy.

Driven by higher risk appetite and improved growth expectations, equities and other growth- and risk-sensitive assets performed strongly until the end of March. US and Asian equity markets firmed the most, in line with the better macroeconomic outlook for these regions. The S&P 500 gained about 12% in the first quarter, the largest one-quarter increase for a decade, despite a slowdown in projected earnings increases. Valuation ratios for equity markets in advanced and emerging economies also picked up, recovering from the lows seen in late 2011.

The optimism about the recovery also had a visible influence on commodity markets, with both energy and industrial metal prices seeing continued upward pressure. This was primarily due to tight demand and supply constellations, although in the case of oil concerns about potential further supply disruptions and geopolitical risks added to the pressure, and crude oil traded above $100 per barrel for a large part of the period.

BIS observed that optimism in financial markets began to evaporate in the second half of March on the back of renewed concerns about euro area growth, especially in Spain and Italy. "The mood shifted as it became increasingly clear that monetary policy actions alone would not be sufficient to resolve underlying euro area economic problems. A trickle of weaker than expected economic data cast further doubts on the strength of the global growth recovery."

Fading LTRO market impact, worries about a possible negative short-term growth impact of fiscal consolidation in Spain and the slow pace of labour market and other structural reforms in Italy were reflected in rising sovereign bond yields. Between mid-March and early April, Spanish and Italian yields edged up significantly.

Sovereign spreads against German bunds widened considerably over this period. Early releases of weak euro area purchasing managers' indices and less positive business climate surveys also contributed to a somewhat less positive growth picture for France and Germany.

Investors also retreated when Standard & Poor's downgraded Spain and several of the country's biggest financial institutions on 26 April. The sovereign rating was lowered two notches to BBB+. This was clearly reflected at a 2.5 billion euros bond auction on 2 May, with yields surging by around 140 basis points for shorter-term bonds.

"The change to a more negative outlook for the euro area was also reflected in the early May statement by the ECB, which no longer contained references to inflationary upside risks and described longer-term risks to inflation as broadly balanced," said BIS.

BIS underscored that fading recovery momentum in the United States added further strains to an already uncertain outlook about the health of the global economy. Weaker than expected data on payroll growth released on 6 April weighed heavily on market sentiment. The March increase of only 120,000 in the early release of US non-farm payroll employment figures was well below expectations and pointed to a still fragile US economic recovery.

"The strongest market reactions were seen in European equity and bond markets when they reopened after the Easter weekend. The renewed scepticism meant that bond yields in major advanced economies fell to record lows. This most likely reflected a flight to safety by investors combined with expectations of continued accommodative monetary policies in advanced economies."

BIS found that global equity prices began to decline in late March and volatility increased as recovery hopes began to fade and concerns about the European situation resurfaced. This was in stark contrast to the strong recovery of equity markets early in the year, which had largely been driven by shrinking risk aversion, lower perceived tail risk and the recovery outlook.

The resurfacing of uncertainty was reflected in plummeting bank equity prices. Euro area, US and Swiss bank equity prices continued to underperform the broader market, further depressing market valuations. Most starkly, market capitalisations of euro area bank equity were below 50% of tangible book value at the end of April 2012.

European banks' issuance of unsecured long-term debt remained positive, but began to taper off again during April. Market conditions nevertheless remained difficult for a number of banks from the euro area periphery which found it difficult to place unsecured debt with investors.

Market participants, however, regarded this as less worrisome than during the second half of 2011, most likely in light of the buffers built up by the high bond issuance in the first quarter and the ample longer-term funds provided by the ECB's LTROs.

Market developments during May clearly indicated that euro area political events significantly added to investor uncertainty, said BIS.

Initial market reactions to the presidential election in France and the Greek parliamentary election, both held on 6 May, were mixed. Greek and French as well as Asian equity markets declined. Yields on Greek bonds initially rose by nearly 2 percentage points and other southern European government bonds also experienced yield increases.

Equity markets in the rest of Europe and the United States, however, quickly recovered, and an auction of French short-term government bonds went smoothly. In the days that followed, post-election political deadlock in Greece and concerns about Spanish banks added to the uncertain outlook for the euro area.

"In this challenging environment, investor worries about a possible Greek exit from the euro and potential wider impact intensified," said BIS, noting that the most visible initial market reaction was in foreign exchange markets, where the euro started to depreciate against the US dollar. At the same time, option prices pointed to a sharp increase in perceived depreciation risk for the euro against other major currencies.

At the same time, said BIS, data on outstanding futures contracts continue to point towards financial investors expecting the euro to weaken. Positioning data pointed to sterling being used as a hedge against negative euro surprises. Sterling may also have benefited from shifts in currency allocations of sovereign foreign exchange reserves.

According to BIS, concerns about the growth outlook for the advanced economies also prompted investors to reconsider the resilience of emerging market growth.

In China, economic indicators confirmed that growth is gradually slowing as a result of last year's policy tightening and lower external demand. Economic data for April on industrial production, trade, investment, and real estate prices and investment confirmed that the economy decelerated along a manageable path. The combination of slower growth, lower inflation and continued declines in house prices in most Chinese cities prompted the Chinese central bank to quickly lower banks' reserve requirement ratio on 12 May, citing the need to achieve a stable increase in economic growth.

BIS said that the move prompted expectations of further monetary policy easing. Consistent with this, one-year non-deliverable renminbi/US dollar forwards began to price in a mild depreciation of the renminbi against the US dollar during the first half of May.

Economic indicators also pointed to a growth slowdown in Latin America and eastern Europe. Responding to slower growth and easing inflationary pressures, the Central Bank of Brazil cut its policy rate by 75 basis points to 9% in April. This meant that the policy rate is now 300 basis points lower than its recent peak in 2011. This put further downward pressure on the Brazilian real, which depreciated significantly against the US dollar in April.

After a brief spell of strong capital inflows in the first two months of the year, inflows into emerging market economies slowed down starting in March. The lower capital inflows were reflected in the returns on emerging market bonds, which declined sharply towards the end of the period, particularly compared to the high returns earlier in the year. A similar pattern had prevailed during the latter part of 2011.

According to BIS, inflows to emerging market bond funds increased significantly during the first weeks of May as euro area uncertainties returned. In contrast, funds focused on western European bonds saw outflows.

Meanwhile, emerging market equity funds were more clearly affected by the less favourable growth outlook, and began to experience outflows during April. Emerging market exchange rates also reflected the change in mood during April and May, with a large number of currencies giving up all their earlier gains relative to the US dollar, BIS concluded. +