TWN Info Service on Finance and Development (Sept12/03)
22 September 2012
Third World Network

Weak growth, Euro area concerns push yields to record lows
Published in SUNS #7439 dated 18 September 2012

Geneva, 17 Sep (Kanaga Raja) -- Together with central bank actions, the combination of weak growth and portfolio re-allocations driven by concerns about sovereign risk in the euro area pushed yields on the debt of a number of highly rated sovereigns to unprecedented lows, according to the Bank for International Settlements (BIS).

In its latest quarterly review released on Monday, the Basel-based BIS said that in a range of European countries, nominal yields on short-term government bonds were even deep in negative territory.

"Such low yields on advanced economy government bonds spurred investors to search for investment opportunities that offered some extra return. The result was a rally in equities and corporate bonds. Search for yield may also partly explain the extraordinarily low volatility in credit, foreign exchange and equity markets over the past several months," BIS added.

During the period from mid-June to mid-September, BIS found that the trajectory of global growth shifted downwards and concerns about the sustainability of euro area government debt and the future of the monetary union gained new traction.

"Against the backdrop of lower growth, many central banks loosened monetary policy, cutting interest rates or expanding unconventional policies. Some of the policy measures and announcements triggered large asset price reactions."

According to the quarterly review, with macroeconomic data releases surprising mostly on the downside, it became increasingly clear that global economic growth had faltered. Provisional estimates suggested that growth in the second quarter had slowed moderately to 0.4% in the United States and to 0.3% in Japan. The euro area economy contracted by 0.2% and that of the United Kingdom by 0.7%.

The weakness also spread to Germany and several emerging market economies with previously more robust growth.

For the United States, some business cycle indicators such as non-farm payrolls turned out slightly better than expected in July. Nevertheless, the economic situation remained fragile, with uncertainty about major fiscal tightening scheduled for the start of 2013 weighing on the growth outlook. Chinese growth fell in the second quarter to its lowest level in three years, and weaker-than-expected purchasing manager figures pointed to a further slowdown of economic activity.

This negative news had surprisingly little effect on the prices of growth-sensitive assets. Prices of industrial metals such as copper did fall. Energy prices, however, picked up as a consequence of tight oil supply conditions and rising international political tensions with Iran. Global equity prices also rose, including in cyclical sectors. The rise in equity prices was supported by corporate earnings exceeding expectations.

During the recent earnings season in the United States and Germany, for example, profits of S&P 500 and DAX companies exceeded analysts' forecasts by about 5% and 16%, respectively. Equity prices also reacted strongly to announcements of additional central bank measures to support the economy and were affected by expectations about further stimulus should the economic outlook deteriorate further. This points to expected lower discount rates as another driver of recent equity price increases.

According to BIS, the euro area debt crisis continued to be a key concern for global investors. Mid-June elections in Greece led to the formation of a pro-euro coalition government, easing fears of an imminent exit from the single currency. Greek government bond yields subsequently fell from their post-debt restructuring peaks. Nevertheless, investors anxiously awaited the outcome of an assessment by the "troika" of Greek compliance with the terms of its support later in the year.

Meanwhile, Spain's borrowing costs rose significantly when the government asked for international financing to help recapitalise the country's banks in early June. As investors feared that their claims would become further subordinated to the new loans, the request for international credit led to a surge in Spanish government bond yields over much of June and July.

While EU finance ministers confirmed in late July that the new loans will not become senior to existing debt, the terms of the recapitalisation did require some write-downs on subordinated bank debt. Credit default swap (CDS) premia on subordinated debt issued by several Spanish banks rose following an early trickle of this news on 11 July.

Premia on senior debt also rose as investors acknowledged the risk that it could be similarly affected in the future. Spanish bank-covered bond spreads increased as well, partly reflecting the effects of the weak economy on the quality of collateral pools, composed largely of property-related loans.

BIS stressed that uncertainty about the effect of the international credit on the sovereign debt burden was another key driver of Spain's surging borrowing costs. This was further reinforced by the deepening of the country's recession and by new requests by some Spanish regions for emergency credit lines from the central government.

All this led Spanish 10-year sovereign yields to increase by about 70 basis points to reach a peak of 7.6% on 24 July. The distress was even more pronounced in the case of shorter-term bonds, with two-year yields climbing more than 170 basis points to 6.8% by the end of July.

Other euro area sovereign bond markets also faced selling pressure over this period. Notably, 10-year yields on Italian government debt tracked higher for much of July, reaching a peak of 6.6% on 24 July. Contagion from Spain may have accounted for part of this rise, but domestic factors also played a role as the Italian central government provided financial assistance to Sicily and Moody's downgraded Italy's sovereign rating by two notches on 13 July.

"In currency markets, the trade-weighted external value of the euro declined up to the end of July as capital flowed out of the euro area."

Following the ECB President's statement in a speech on 26 July that "within our mandate, the ECB is ready to do whatever it takes to preserve the euro", yields on Italian and Spanish bonds fell significantly. Yields on shorter-term paper dropped the most.

"Market expectations that any prospective ECB policy action would focus on purchasing shorter-term bonds may have accounted for part of this decline," BIS underscored.

It noted that details of the ECB's new programme of outright monetary transactions (OMTs) were finally unveiled on 6 September. The programme involves discretionary sterilised purchases of short-term sovereign bonds under certain conditions and is subject to a prior request by the respective country's government for international assistance via the European Financial Stability Facility/European Stability Mechanism (EFSF/ESM).

The news of a more active stance of the ECB had a broad impact on market sentiment. Global equity prices surged over much of August. Yields on German bunds and other higher-rated euro area government bonds rose. Also around this time, the Irish government regained access to international capital markets by issuing longer-term bonds with yields below those of Spain.

The value of the euro against other major currencies recovered during most of August. Nevertheless, exchange rate risk reversals suggested that investors continued to pay a premium to hedge against future sharp decreases in the value of the currency.

Against the background of the weaker growth outlook, central banks in both emerging market and advanced economies took further steps to ease monetary policy. The central banks of Brazil, China, Colombia, the Czech Republic, Israel, Korea, the Philippines and South Africa lowered policy rates. The rate cuts in China followed reductions in bank reserve requirement ratios earlier in the year. Forecasts of future policy rates in emerging market economies imply few further cuts, however.

Central banks in advanced economies also eased monetary policy further. In early July, the ECB lowered its main refinancing rate by 25 basis points to 75 basis points and cut the interest rate on its deposit facility to zero.

This brought the remuneration of balances in the deposit facility into line with that on banks' current accounts, reducing the incentive to transfer excess reserves into the deposit facility at the end of each business day. That said, banks kept the total amount of reserves unchanged. Also, some money market funds stopped accepting new investments, as negative nominal interest rates made it difficult for them to offer positive returns to their investors.

With policy rates already close to zero and expected to remain around this level for quite some time, central banks in large advanced economies extended or renewed unconventional monetary policies targeting long-term high-quality assets.

On 5 July, the Bank of England announced an increase in the size of its Asset Purchase Facility by 50 billion pounds sterling to a total of 375 billion pounds sterling, financed by an expansion of central bank reserves.

Likewise, on 20 June, the Federal Reserve announced a second programme to extend the maturity of its Treasury holdings. The programme involves buying $267 billion of Treasury securities with remaining maturities of six to 30 years financed by the sale or redemption of an equal amount of Treasuries with maturities of three years or less. The Bank of Japan continued its regular purchases as a part of its Asset Purchase Program.

"Discussions about central bank asset purchases featured prominently in financial commentary during the period. But, as it turned out, the actual announcements had surprisingly little impact on asset prices."

[On 12 September, US Fed Chair Ben Bernanke announced a new stimulus programme, a QE3, of purchase of $40 billion a month of mortgage bonds, and potentially other assets, until the US job market improved substantially. The Fed also said it intended to hold short-term interest rates near zero at least through the middle of 2015, half a year longer than in its previous statement. The New York Times reported that the Bernanke announcement was "an indication of the Fed's intention to keep its foot on the gas well past that point." - SUNS]

By contrast, said the BIS quarterly review, government bond yields reacted strongly to news about the future path of short-term interest rates. For example, yields on two-year US Treasury notes fell by 10 basis points on 22 August after the publication of the minutes of the latest meeting of the Federal Open Market Committee.

"Observers interpreted the minutes as indicating that the federal funds rate target could remain low for even longer than previously expected."

Yields also dropped significantly on 31 August when Chairman Ben Bernanke expressed concern over the US labour market situation and alluded to costs and benefits of further unconventional policies in his address at the Jackson Hole conference. This indicated that market participants remained highly sensitive to news of future policy direction.

In addition to extending or renewing earlier programmes, some central banks took measures targeted more specifically at restoring the flow of credit to the economy. In his Mansion House speech in London on 14 June, the Governor of the Bank of England announced a new Funding for Lending Scheme (FLS). The FLS provides funding to banks on terms that are conditional upon the performance of banks in sustaining or expanding their lending to UK households and non-financial companies. Corporate bond yields dropped by 6 basis points on the following trading day, and yields on gilts fell 5-10 basis points.

"The latter decline possibly reflected market participants' expectation that growth would remain weak and monetary policy expansionary for longer than previously thought."

"A combination of weak growth, central bank policy actions and portfolio re-allocations driven by concerns about sovereign risk in the euro area pushed yields to unprecedented lows," BIS emphasised.

Yields on the short-term paper of a few highly rated sovereigns, most notably Switzerland and Germany, had already been close to zero (or negative) during earlier euro area distress episodes. These dynamics gained additional force after the ECB cut the interest paid on its deposit facility to zero on 5 July.

In the days after the announcement, yields on higher-rated European short-term government bonds plunged to lows not previously recorded. Short-term yields of the Netherlands, Finland and Austria, for instance, decreased sharply and temporarily turned negative. Their spreads over German bunds tightened considerably. At the most extreme, yields on Swiss and Danish two-year government bonds fell below -40 basis points and -30 basis points, respectively. Both countries (effectively) link their currency to the euro.

In an effort to reduce pressure on the krone, the Danish central bank entered uncharted waters by lowering the rate on its deposit facility to -20 basis points. In primary markets, Germany sold over 4 billion euros of two-year Treasury notes at an average yield of -6 basis points in mid-July. France, Belgium and the Netherlands also held auctions in which short-term government paper was sold to investors at negative yields.

Long-term government bond yields in several countries also fell to record lows. In July, 10-year US government bond yields reached their lowest for more than 200 years.

With sovereign yields at historical lows, investors increasingly looked beyond benchmark government bonds in search of reasonably safe investments offering some extra yield. Such portfolio rebalancing is one of the key objectives of unconventional policies, intended to stimulate investor risk-taking by reducing the attractiveness of government securities relative to risky assets.

Corporate bond spreads fell as investors raised their credit risk exposure to the corporate sector and the asset class saw large inflows from investors. From mid-June to end-August, bond spreads moved down by 17 basis points for AAA-rated corporates and more than 30 basis points for other investment grade corporate bonds.

Consistent with search for yield behaviour and increased risk-taking induced by the low rate environment, issuance of high-yield bonds in primary markets picked up strongly. Lower-rated corporate issuers took advantage of benign market conditions to place large amounts of high-yield bonds with investors. High-yield bond funds also attracted large inflows.

Likewise, emerging market bond funds saw inflows from investors willing to take on credit risk to earn some extra yield. This was also reflected in the tightening of spreads on emerging market debt securities.

The volatility of risky assets remained extraordinarily subdued given the concerns about the euro area debt crisis and the poor outlook for growth. Volatility was low compared to recent history in credit, foreign exchange and equity markets.

On 13 August, the implied volatility index (VIX) computed from the prices of US equity market options fell to its lowest value since June 2007. With real government bond yields in negative territory in many countries, this means that equity valuations have become more attractive relative to bonds, which in turn may have pushed some investors to increase the equity share of their portfolios.

"As a consequence, assets traditionally perceived as risky may have been less affected by the deterioration of the growth outlook and the euro area strains compared to previous episodes," BIS concluded. +