TWN Info Service on Finance and Development (Apr13/02)
8 April 2013
Third World Network
 
A renewed sense of optimism permeates markets - BIS
Published in SUNS #7556 dated  2 April 2013
 
Geneva, 28 Mar (Kanaga Raja) -- Continued weakness in economic fundamentals led to extended accommodation in the form of monetary easing and a moderation in the pace of near-term fiscal consolidation, and the resulting fall in perceived downside risk buoyed financial markets and drove investors into riskier asset classes, the Bank for International Settlements (BIS) has said.
 
In its latest Quarterly Review of March 2013, the Basel-based BIS said: "Extensive policy support has infused financial markets with a renewed sense of optimism over the last few months."
 
"Safe haven flows ebbed as funds poured into equity and higher-yielding debt instruments, including those in emerging markets and the euro area periphery. These developments supported a renewed sense of optimism in financial markets with which macroeconomic performance has yet to catch up," it added.
 
[The Review covers the period before the most recent crisis in the eurozone - the banking crisis in Cyprus, its ‘rescue', and the aftermath of the various pronouncements on the crisis and the rescue from eurozone financial figures - the Dutch finance minister chairing the eurozone finance ministers, and the German finance minister - and its effects on the markets, and renewed doubts, perceptions and speculation about the euro and the EU project. - SUNS.]
 
According to the Review, as the new year started, the asset valuation gains of the previous months continued. The global equity index has gained 5% since early January, and 23% since the low reached in June 2012 when the euro area crisis was still in full swing and global growth appeared to be faltering.
 
The trend in the major equity markets had gathered momentum in November, triggering a rally in January. Throughout this time, volatility in most major equity markets gradually declined, eventually reaching its lowest level since May 2007 in a sign that market participants regarded sharp market movements as less likely going forward.
 
By limiting perceived downside risks, policy accommodation played a central role in these developments. Risk reversals, an option-based measure of tail risk, declined substantially in response to central bank announcements. And the cost of insurance protection against an equity market drop fell most sharply in July and September 2012 in response to key ECB (European Central Bank) announcements, and again in early January following the US "fiscal cliff" deal.
 
BIS noted that mitigation of downside risks was also reflected in debt and currency markets. Yields on US Treasuries and German government bonds, often viewed as safe havens in times of elevated uncertainty, rose in January with no commensurate rise in inflation expectations. Similarly, the preference for the Swiss franc as an alternative to the euro waned for the first time since 2011. The exchange rate between these two neighbouring currencies moved away from the ceiling of CHF 1.20 to the euro set by the Swiss National Bank.
 
Financial markets rallied even as growth data were signalling continued macroeconomic weakness in the advanced economies. The United Kingdom and the euro area suffered a contraction in 2012, while the United States experienced subdued growth. Indeed, in the OECD (Organisation for Economic Cooperation and Development) as a whole, GDP shrank in the fourth quarter as Germany and France ended the year with a dip.
 
In contrast to improving financial market conditions since mid-2012, quarterly growth rates in many countries were gradually falling and so were growth forecasts for 2013. An exception to this trend was Japan recently, where the anticipation of expansionary policies fuelled growth expectations.
 
"The evolution of expected corporate profits conveys a similar impression. In the course of 2012, forecasts of earnings per share saw successive downward revisions in the United States and weak upward revisions in the euro area. This suggests that improved fundamentals were not the main factor underpinning the recent equity market rally."
 
Renewed optimism in financial markets over the last few months mainly hinged on continued policy accommodation, reinforced by a few upside data surprises, said BIS, adding that market participants reacted with growing optimism to a range of policy measures taken to support the fragile economic recovery.
 
On the fiscal side, a number of short-term consolidation measures were postponed or eased. US lawmakers averted the fiscal cliff in late December that had threatened to induce a recession in 2013. The combined tax hikes and spending cuts equivalent to 5% of GDP gave way to a more moderate deficit reduction by automatic "sequester" budget cuts, resulting in $42 billion less spending up to September 2013 by Congressional Budget Office estimates.
 
According to BIS, this boosted equity markets in early January, as did the temporary suspension of the statutory debt limit later that month.
 
Also in January, Japan's new government turned its campaign promise into a stimulus package of 10 trillion Yen to boost growth and overcome deflation, and the markets rallied with little concern over Japan's debt burden.
 
The administration's 13 trillion Yen supplementary budget containing the stimulus package was largely debt-financed, with 51% of the additional spending not being matched by planned tax revenue.
 
In Europe, the gradual relaxation in financial markets made fiscal consolidation less urgent. Assurances in July 2012 that "the ECB is ready to do whatever it takes to preserve the euro" had been followed by the announcement of a backstop (Outright Monetary Transactions - OMTs) allowing for unlimited sovereign bond purchases when a member country submits to a macroeconomic adjustment programme.
 
"As investors moved back into euro area assets and unwound short positions, asset prices increasingly reflected the view that the ECB's commitment had removed the risk of a possible member country exit and currency re-denomination."
 
In addition, said the BIS Review, the poor euro area growth outlook led the authorities to allow several countries additional time to meet deficit targets. The pacing of fiscal tightening, both in the euro area and in the United States and Japan, helped lift equity markets.
 
Other important parts of the global economy also saw policy support growth; to avert the risk of a hard landing in China, the authorities expanded infrastructure investment while promoting bank lending and non-bank financing.
 
Market participants also reacted positively to recent regulatory developments. On 7 January, the Basel Committee on Banking Supervision issued the revised liquidity coverage ratio (LCR) to be phased in more slowly with more lenient run-off assumptions and a broader definition of liquid assets (now including qualified mortgage-backed securities - MBS, corporate bonds and equity).
 
The market reaction included equity gains and credit default swap (CDS) spread compression, particularly among banks with lower liquidity ratios.
 
In the United Kingdom, the Financial Services Authority provided assurances of regulatory flexibility to help support bank lending. Meanwhile, the UK government proceeded with plans to ring-fence UK banking groups, while turning down some of the stricter recommendations of the Vickers Report.
 
Similarly, a European Commissioner stated that any implementation of the Liikanen proposal to separate trading activities from deposit-taking would have to avoid penalising lenders that were supporting the economy, while two alternative proposals emerged from France and Germany.
 
"Market analysts regarded these regulatory changes as helpful in relaxing some of the near-term challenges weighing on banks' earnings prospects," BIS said.
 
With respect to the monetary side, BIS noted, for example, that the Bank of England chose to allow inflation to remain above target over the near term.
 
The Federal Reserve in December decided to keep the federal funds rate below 0.25% at least as long as unemployment remains above 6.5%, provided inflation expectations stay well anchored.
 
Japan's resolve to lift growth and end deflation has created expectations that the Bank of Japan will further expand quantitative easing on the way to a higher inflation target of 2%.
 
In this subdued macroeconomic environment, core government bond markets still benefited from sustained demand for high-quality paper. Continued monetary easing led the market to perceive that monetary tightening remained a remote prospect.
 
An analysis of nominal yields on US Treasuries shows that the term premium, which compensates investors for the risks of inflation and movements in real rates, turned negative in 2011 and continued to decrease through 2012; in the euro area, the premium turned negative in mid-2012. In both markets, the premium decreased to levels representing record lows since at least 2000.
 
The major central banks continued to follow quantitative easing policies. The Federal Reserve continued its purchases of agency MBS and long-term Treasury securities at the rate of $85 billion per month, while the Bank of England complemented its asset purchases with a scheme to encourage bank lending to households and companies.
 
Between July 2007 and February 2013, the Federal Reserve's and the Bank of England's balance sheets grew by 254% and 394%, respectively, compared with 130% for the Euro-system.
 
"Tail risk concerns gave way to optimism as global financial markets took their cue from policy support. The reduction in downside risk in the euro area drove the euro sharply higher in January. This appreciation went hand in hand with the unwinding of short positions in the euro. Following these movements, investors regarded any further depreciation as less likely, in both the near and medium term."
 
According to BIS, market participants regarded the ECB's OMT facility as the single most important measure taken to mitigate downside risk. As market sentiment turned in September and improved further in early 2013, the euro area debt crisis weighed less on financial markets than at any time since 2010.
 
During this time, the bond yields of stressed euro area sovereigns declined across maturities. Spreads over German bunds fell by half from their June 2012 levels (and by nearly two thirds in Ireland and Portugal), settling in a range of 2.2 to 4.3% for the five-year maturity. As risk premia declined, the credit curve became upward-sloping once again.
 
During much of 2011-12, CDS spreads had been abnormally high at the short end of the maturity spectrum, indicating that market participants had viewed a credit event as imminent.
 
As market participants gradually moved back into euro area assets, sovereigns in the periphery were able to issue debt on better terms, said BIS, noting that Italian and Spanish bond auctions elicited robust demand in spite of deepening recessions and political uncertainty.
 
In a sign that fiscal consolidation ultimately improved bond market access, Ireland and Portugal returned to the international debt market with major bond issues. This was seen as an important step towards securing financing outside their official programmes. Likewise, some of the largest financial institutions headquartered in the euro area periphery regained access to wholesale funding markets.
 
The developments since last July boosted financial markets more broadly and also improved the condition of euro area banks. The interplay between the sovereign debt crisis and banking distress began to run in reverse, with stronger sovereigns leading to stronger banks.
 
In addition, important measures were taken to strengthen banks, notably the 40 billion euro recapitalisation of Spanish banks financed out of the European Stability Mechanism. As a result, CDS spreads referencing euro area banks have declined substantially over the past six months in parallel to falling sovereign spreads.
 
BIS further underlined that bank equity has consistently outperformed the general index in the past several months: since June 2012, the European bank sub-index has gained 46%, twice the percentage increase of the European index. During this period, deposit funding has also improved and earlier outflows from banks in Greece and Spain began to reverse.
 
The improvement in bank funding conditions allowed hundreds of euro area banks to repay a higher than expected 137 billion euros in LTRO (longer-term re-financing operation) funding to the ECB in January. The 61 billion euro repayment in February, while this time only half of the market's median forecast, elicited no significant market reaction. The cumulative repayments reduced the ECB's net lending to banks to 596 billion euros.
 
"It remains to be seen whether banks' improved condition translates into greater credit supply supporting an eventual economic recovery. Even as funding conditions eased, banks reported net tightening in their lending standards. Earnings prospects remain limited by various factors ranging from a weak economy to restructuring and litigation challenges."
 
Moreover, BIS added, on the demand side, many households still sought to repay debt and firms increasingly tapped the market to reduce their reliance on banks. These developments accounted for relatively subdued credit growth.
 
As tail risks receded, market participants became more willing to take on risk. This lifted equity prices generally, and the more risk-sensitive cyclical sectors in particular, extending a trend that had started in November 2012. In bond markets, high-yield corporate bond spreads narrowed to levels last seen prior to the euro area debt crisis. Corporate bond yields declined more broadly, raising the relative attractiveness of investing in equity markets.
 
Against this backdrop, said BIS, capital flows moved into riskier asset classes. In 2012, funds investing in corporate bonds in the developed markets saw the largest inflows, but investors progressively moved into more risky asset categories. Inflows into equity funds soared in early 2013. Capital inflows to emerging market (EM) funds also surged, the largest part going to dedicated equity funds.
 
And within the emerging market bond fund category, investors increasingly sought funds investing in local currency-denominated bonds, exposing themselves to emerging market currency risk, BIS added. +