TWN Info Service on Finance and Development (Sept11/04)
26 September 2011
Third World Network

Weak outlook drove down asset prices, fuelled debt concerns
Published in SUNS #7221 Tuesday 20 September 2011

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 Greece, Ireland and Portugal to Italy and Spain. This led to tighter funding conditions for European banks and even affected pricing in euro area core sovereign debt markets.

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 Europe and slightly smaller falls in emerging market economies (EMEs). Large declines in prices of cyclically sensitive assets pulled down average prices. Corporate credit spreads generally widened, with greater increases for lower-rated debt, which is more vulnerable to non-payment in a downturn. In addition, reflecting expectations of weaker demand for these key production inputs, prices of energy and industrial metals decreased sharply.

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 Germany.

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 United States in July. Global equity prices fell by 2% on average on the following day. The S&P 500 Index of US equity prices then declined by 4.5% on 18 August, when a measure of US manufacturing activity in August published by the Federal Reserve Bank of Philadelphia plunged to levels only previously recorded shortly before or during recessions.

"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 US authorities cut payroll taxes, extended the duration of income tax cuts and unemployment benefits, and launched a second round of quantitative easing. At the same time, local governments in China provided more financing for infrastructure and housing developments.

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."

In the United States, the Federal Reserve announced on 9 August that it expected to keep its policy rate at exceptionally low levels until at least mid-2013. This pushed down federal funds futures rates and, hence, longer-term interest rates and boosted US and international equity prices.

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 China and India. The People's Bank of China further tightened monetary policy by broadening the scope of reserve requirements to cover margin deposits after inflation reached a three-year high of 6.5% in July. In contrast, the central banks of Brazil and Turkey cut policy rates in reaction to signs of slower growth.

"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 US government at ever lower interest rates. However, few expected additional fiscal stimulus, at least during the early part of the review period. Indeed, President Barack Obama signed an agreement on 2 August to cut planned spending while raising the statutory ceiling on government debt.

Investors then interpreted Standard & Poor's credit rating downgrade of US long-term debt from AAA to AA+, which took place on 5 August, as increasing the urgency of fiscal consolidation, which would weigh on medium-term growth. This contributed to a fall of over 6% in the S&P 500 Index on the next business day. By early September, however, further signs of weakness in the US economy led the US President to propose a $447 billion fiscal stimulus package to Congress, although the reaction of equity markets was muted.

"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 US debt ceiling negotiations generated some short-lived stresses in money markets. Reaching the ceiling would have forced the federal government to choose whom it would pay. This politically extremely unappealing prospect led most market participants to expect that an agreement would be reached to allow the debt ceiling to be raised. Such an agreement was signed on 2 August, the day that the US Treasury had estimated its ability to borrow would otherwise have been exhausted.

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 US slowdown, faltering growth in France and Germany and declining momentum from emerging markets, market participants followed euro area developments with increasing anxiety amid political uncertainty, the review observes.

"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 of Greece, Ireland and Portugal, and increasing doubts over their ability to return to bond markets in the time specified in official support programmes, continued to drive the price of sovereign debt."

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 yields of Greece and the other programme countries by hundreds of basis points, with less movement at longer maturities. Lower interest rates and longer maturities on future EFSF loans and a bond exchange involving private investors lowered the future debt servicing burden, although the extent of private sector involvement depended on which of the several options were finally chosen.

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 Greece's sovereign rating.

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 Italy and Spain had decoupled from tensions in the euro area periphery. The self-perpetuating dynamics gathered pace through July, with bondholders selling in anticipation of future losses in their portfolios, thereby raising volatility and perceived risk, which led to further selling. As a result, on 4 August, yields on Italian and Spanish government bonds spiked to 6.2%.

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 Italy issued 10-year bonds on 30 August, after backtracking on proposed fiscal consolidation plans. Two days later, Spain was able to issue five-year bonds at a yield of 4.49%, 38 basis points lower than in the previous auction, after the main political parties had agreed on a constitutional deficit limit proposal the week before.

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 France, Italy and Spain demonstrated renewed resolve to implement austerity measures and the German constitutional court rejected challenges to the Greek rescue package and the establishment of the EFSF.

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 Italy and Spain led to a broad-based sell-off of bank stocks and bonds. Selling pressure went from banks in Italy and Spain to those in Belgium and France, and later extended to banks across the entire continent, including those headquartered in the Nordic countries.

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 Atlantic. In the United States, new lawsuits over sub-prime mortgages compounded the pressure on bank equity resulting from negative growth revisions. The market's outlook on the banking industry as a whole remained clouded by growth concerns and sovereign risk as well as low interest rates and regulatory changes, a combination that left investors unsettled about the industry's future course and earnings potential."

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 UK inflation-linked bonds entered negative territory.

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. In Japan, for example, the authorities sold yen in the foreign exchange markets from early August.

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.