Info Service on Finance and Development (Jan13/01)
3 January 2013
Third World Network
Easing of near-term risks, looser policies rallied markets - BIS
Published in SUNS #7506 dated 21 December 2012
Geneva, 20 Dec (Kanaga Raja) - Despite forecasters cutting their projections
for global economic growth in the three months to early December,
prices of most growth-sensitive assets rose, benefiting from further
loosening of monetary policies and perceptions that some major near-term
downside risks to the world economy had diminished, the Bank for International
Settlements (BIS) has said.
In providing this assessment in its latest Quarterly Review of international
banking and financial market developments, BIS said last week that
in particular, "asset valuations reacted positively to new policy
measures aimed at tackling the euro area crisis. They were also supported
by news suggesting that a sharp and prolonged fall in Chinese economic
growth was less likely."
[Meanwhile, in its latest projection of World Economic Prospects released
this week, the UN warned that growth of the world economy "weakened
considerably during 2012 and is expected to remain subdued in the
coming two years."]
However, cautioned BIS, downside risks remained and uncertainty about
fiscal policy in the United States, which was on course to tighten
substantially in the near term, encouraged cash hoarding and weighed
on the prices of assets most vulnerable to budget cuts.
Yet, equity implied volatilities, including those with longer horizons,
fell close to the historically low levels of the mid-2000s. Similarly,
some asset prices started to appear highly valued in historical terms
relative to indicators of their riskiness. For example, global high-yield
corporate bond spreads fell to levels comparable to those of late
2007, but with the default rate on these bonds running at around 3%,
whereas it was closer to 1% in late 2007. The same was true of investment
grade corporate bond spreads, but with respective default rates of
a little over 1% and around 0.5%.
"Indeed, numerous bond investors said that they felt less well
compensated for risk than in the past, but that they had little alternative
with rates on many bank deposits close to zero and the supply of other
low-risk investments in decline."
According to the BIS Quarterly Review, the prices of most risky assets
increased between early September and early December. In the advanced
economies, yields on both investment grade and sub-investment grade
corporate bonds fell to their lowest levels since before the 2008
financial crisis. The same was true of yields on emerging market bonds,
whether issued by sovereigns or corporates, or denominated in local
or international currencies. And yields on bonds backed by mortgages
and other collateral fell to their lowest levels ever. Meanwhile,
equity prices mostly rose during the early part of the period, although
they fell back somewhat later on.
Unusually, BIS found that equity and fixed income gains coincided
with a weakening of the global economic outlook. Forecasters cut their
projections for 2012 and 2013 global economic growth. Without any
significant offsetting upward revisions, they substantially reduced
their forecasts for Greece, Italy and Spain in Europe, as well as
for Brazil, China and India in the emerging world.
In the past, it noted, falling growth forecasts have usually been
associated with rising expected default rates and higher bond yields.
But this time, bond yields fell. Similarly, most equity prices ended
the period a little above their starting levels, despite weakening
corporate earnings expectations. Earnings expectations for US companies
in the S&P 500 Index dropped particularly sharply following a
decline in reported earnings - the first in 11 quarters - and as an
unusually high proportion of firms warned that future profits could
fall short of analysts' forecasts.
Market participants attributed a significant part of the rally in
asset prices to further loosening by central banks, notably the Federal
Reserve. On 13 September, the Fed announced that it would immediately
begin expanding its balance sheet through monthly purchases of $40
billion worth of mortgage-backed securities. In contrast to previous
rounds of asset buying, US policymakers left the size of the programme
open-ended, stating that it would continue until the labour market
outlook had substantially improved.
At the same time, the Fed pushed its forward guidance several months
further into the future, saying that it expected to maintain its policy
rate at exceptionally low levels until at least mid-2015, even if
the US economic recovery had strengthened by then.
[In its latest policy statement of 12 December, the Fed's Open Market
Committee has announced its intention to keep its current federal
rate at 0 to 1/4, as long as the unemployment rate remains above 6-1/2
percent. According to the Fed, for the period between one and two
years ahead, US inflation is projected to be no more than a half percentage
point above the Committee's 2 percent longer-run goal, and longer-term
inflation expectations continue to be well anchored. - SUNS]
The Bank of Japan also extended its asset purchasing programme, both
in September and October, raising purchases of Japanese government
securities and other assets planned before the end of 2013 by 21 trillion
Yen. Meanwhile, policy rates were cut in Australia, Brazil, Colombia,
the Czech Republic, Hungary, Israel, Korea, the Philippines, Sweden
The Fed's measures had significant, if short-lived, effects on US
financial markets. Most directly, they compressed yields on mortgage-backed
securities, which led to reductions in mortgage rates. As the gap
between these two metrics widened, US bank equity prices increased
relative to the equity market as a whole. In addition, the Federal
Reserve's new commitment to potentially unlimited balance sheet expansion
boosted both market-based indicators of expected inflation and the
prices of precious metals used as inflation hedges.
BIS noted that with this rise in expected inflation, the US dollar
depreciated slightly. Within a few weeks, however, both expected inflation
and the value of the dollar returned to the levels seen before the
13 September announcement, possibly because incoming economic data
suggested less monetary easing than originally expected.
"More broadly, further quantitative stimulus by the major central
banks appeared to nudge investors into taking on more risk. In particular,
developed market corporate bond funds and emerging market government
and corporate bond funds each attracted net inflows."
With investors' demand for risky assets increasing, bond issuers were
able to place more debt than in previous months. This included the
sale of some relatively risky types of bond. For example, non-financial
corporate bond issuance rose to and remained near its year-to-date
peak in September, October and November, with disproportionate increases
in sub-investment grade issuance.
Also during these three months, emerging market bond issuance outpaced
that of the previous year, with placements of corporate bonds rising
by more than those of government bonds. And, over the same period,
European subordinated bond issuance was distinctly stronger than earlier
in the year, not only for financial borrowers, who brought forward
some planned 2013 issuance owing to forthcoming regulatory changes,
but also for non-financial borrowers.
According to BIS, easier monetary policies in advanced economies raised
expectations that capital would flow into emerging market economies,
causing their currencies to appreciate. When this happened in November
2010 and June 2011, the US dollar fell by more than 5%. Yet this time,
the US dollar appreciated in the three months from the beginning of
September, both against a number of individual emerging market currencies
and on a trade-weighted basis.
"Softer growth prospects in emerging markets partly explain why
their currencies and capital flows reacted differently to monetary
easing in advanced economies. They also put downward pressure on commodity
Several emerging market economies used policy measures in an attempt
to stop their currencies from appreciating during the period.
The Brazilian central bank intervened in foreign exchange markets,
and currency traders gained the impression that other central banks
in Latin America and East Asia were also in action. In addition, the
Czech central bank said that it might consider intervention, depending
on how its currency moved. In Korea, the authorities launched an investigation
into compliance with restrictions on banks' foreign exchange positions
that would gain from an appreciation of the local currency. Moreover,
they tightened limits on banks' exposure to currency derivatives.
All these measures were generally associated with more stable currency
values, as evidenced by option implied volatilities.
Asset prices also received support during the period from a perceived
reduction in some major downside risks to the world economy. In particular,
the prospect of a near-term worsening of the euro area crisis appeared
to decline following new policy announcements. Also, the risk of a
sharp and prolonged fall in Chinese growth seemed to recede after
better than expected October economic data were released.
"However, the risk of an abrupt tightening of US fiscal policy
from the beginning of 2013 lingered and even increased, according
to some commentators, after federal elections again delivered a balance
of political power vulnerable to stalemates."
According to the Quarterly Review, changes in the prices of options
insuring against sharp declines in equity prices supported the perceived
evolution of these risks. The cost of insuring against falls of 20%
or more in the EURO STOXX 50 Index, a proxy for a sharp economic crisis
in the euro area, fell in the three months from the beginning of September,
although the price of protection against smaller price declines dropped
by a similar amount.
The cost of insurance against large falls in the Hang Seng Index,
which might occur if Chinese economic growth were to slow sharply,
also declined. The price of protection against smaller price drops
fell by a lesser amount.
By contrast, there was some increase in the cost of insuring against
a fall of 20% or more in the S&P 500 Index, which might accompany
an abrupt tightening of US fiscal policy. This rise slightly outpaced
the cost of insuring against smaller price declines.
In the euro area, BIS noted, the European Central Bank's (ECB) plans
to buy government bonds substantially boosted debt markets and underpinned
financial markets more broadly.
After ECB President Mario Draghi had alluded to these moves in a speech
in London on 26 July, the Governing Council provided details on 6
September. The ECB would buy bonds issued by euro area governments
with residual maturities of one to three years, with the intention
of accepting equal status to other creditors, conditional on those
governments first agreeing to follow an economic adjustment programme.
Yields on bonds of financially strained governments in the region
subsequently fell, having already declined significantly since Mr
Draghi's speech, especially at purchase-eligible maturities.
However, Spanish bond yields soon rebounded. This coincided with upward
revisions to 2011 and anticipated 2012 budget deficits, clarification
that European funds would not be available to finance legacy bank
support programmes and a push for independence by the president of
Catalonia. In contrast, Italian bond yields remained at much lower
levels and in October the government issued a record amount of debt
for a single European offering.
Asset prices rose particularly strongly in Greece, where the government
eventually received further loan disbursements from its IMF/EU programme.
These were due in September, but Greece had slipped behind some of
the programme's economic targets. The government subsequently negotiated
an adjusted programme, which included lower and later payments on
Greece's official debt, transfer to Athens of profits on the Euro-system's
holdings of Greek government bonds and plans for a private sector
According to press reports, many hedge funds bought Greek bonds in
anticipation of such an outcome. This helped to drive yields lower
in the three months to early December. The Athens Stock Exchange equity
price index rose by almost one third over the same period.
Capital flows also seemed to reflect the view that the euro crisis
was less likely to intensify. With investors perceiving a reduced
risk of currency re-denomination, portfolio investments flowed into
Spain and Italy on a net basis in September. At the same time, outflows
of deposits and other funding from banks in these countries slowed
or levelled off.
Separate data show that deposits at these banks also held up in October.
Some of the net capital inflows to Spain and Italy probably came from
Germany, as the Bundesbank saw a reduction in its claims on the ECB
that were generated by net payments from other euro area countries.
Conversely, the Spanish and Italian central banks' liabilities to
the ECB generated by net payments to other euro area countries registered
a decrease. These changes ran counter to the trend of the previous
year or so, said BIS.
Despite this renewed support for the financially strained countries
in the euro area, yields on bonds issued by the financially more robust
governments were essentially unchanged. Yields on two-year bonds issued
by France, Germany and the Netherlands remained close to zero, while
yields on their 10-year debt also hovered at historically very low
levels. Moody's downgrading of France from AAA had little effect on
Financial markets also drew support from news suggesting that a sharp
and prolonged slowdown in Chinese economic growth seemed less likely.
Fears of a "hard landing" in China were allayed, in particular,
by rebounds in industrial production and export growth during October
as well as a survey of purchasing managers. This reduced perceived
default risk for assets vulnerable to a severe economic slowdown,
such as bank loans. Reflecting this, Chinese bank equity prices outperformed
non-bank equity prices in the three months to early December.
Although perceptions of major downside risks may have diminished,
BIS stressed, the effects of weakening economic growth in China nevertheless
spread to other emerging markets, notably in Asia.
Here, exchange rate movements in 2012 had already highlighted the
importance of China to investors in several economies in the region.
In particular, the exchange rates of economies highly dependent on
exporting to China have moved almost in step, suggesting that they
are driven largely by news from China, while those of less dependent
economies have moved more idiosyncratically.
However, not all near-term economic risks diminished, notably in the
United States. Here, the government remained on course to cut its
budget deficit by around 4% of GDP from the beginning of 2013, which
most economists agreed would push the economy into recession. Uncertainty
about whether and how this fiscal drag would be mitigated weighed
on the prices of certain equities.
In particular, said BIS, prices of stocks with high dividend yields
and from the defence sector fell relative to the broader US market.
Such stocks are particularly vulnerable to higher dividend taxes and
spending cuts, respectively. Fiscal uncertainty also prompted US companies
to keep more liquidity on hand in assets such as bank deposits and
marketable securities. This put further downward pressure on the yields
of those assets.
However, BIS added, this near-term uncertainty had almost no effect
between the beginning of September and the end of November on the
future path of medium-term US interest rates as implied by derivatives
prices. This suggests that investors remained confident that the government
would ultimately lower the trajectory of its debt.
[Meanwhile, in its "World Economic Situation and Prospects 2013"
released this week, the UN warned that growth of the world economy
"weakened considerably during 2012 and is expected to remain
subdued in the coming two years". Growth of world gross product
(WGP) is expected to reach 2.2 percent in 2012 and is forecast to
remain well below potential at 2.4 percent in 2013 and 3.2 percent
in 2014. Weaknesses in the major developed economies are at the root
of continued global economic woes. Most of them, but particularly
those in Europe, are dragged into a downward spiral as high unemployment,
continued de-leveraging by firms and households, continued banking
fragility, heightened sovereign risks, fiscal tightening, and slower
growth viciously feed into one another, it added.
[In the baseline outlook for the euro area, GDP is expected to grow
by only 0.3 per cent in 2013 and 1.4 per cent in 2014, a feeble recovery
from a decline of 0.5 per cent in 2012. Because of the dynamics of
the vicious circle, the risk for a much worse scenario remains high.
The United States economy weakened notably during 2012, and growth
prospects for 2013 and 2014 remain sluggish. In the baseline outlook,
gross domestic product (GDP) growth in the United States is forecast
to decelerate to 1.7 per cent in 2013 from an already anaemic pace
of 2.1 per cent in 2012.
[The UN further said that risks remain high for a much bleaker scenario,
emanating from the "fiscal cliff " which would entail a
drop in aggregate demand of as much as 4 per cent of GDP during 2013
and 2014. Adding to the already sombre scenario are anticipated spillover
effects from possible intensification of the euro area crisis, a "hard
landing" of the Chinese economy and greater weakening of other
major developing economies. Unless Congress can reach an agreement
to avert it, the United States will face a sharp change in its government
spending and tax policy at the end of 2012. The tax cuts endorsed
during the Administration of George W. Bush worth $280 billion per
year (often referred to as the "Bush tax cuts"), the 2 percentage
point payroll tax reduction worth $125 billion, and the emergency
unemployment compensation worth $40 billion introduced during the
first term of the Obama Administration, were all designed to expire
at the end of 2012. More specifically, the expiration of the Bush
tax cuts would imply an increase in income tax rates across all income
levels by about 5 percentage points in 2013.
[Among the other changes associated with the expiration of Bush tax
cuts are the phasing out of the reduction in the Federal Child Tax
Credit and an increase in the maximum tax rate for long-term capital
gains by about 5 percentage points. The expiration of the 2-percentage-point
reduction in employee payroll taxes would imply a decline in aggregate
disposable income by about $125 billion. Moreover, the expiration
of emergency unemployment compensation, which was first passed into
law in 2008 and has been extended in the past four years, would imply
a reduction in consumption spending by about $40 billion. On the expenditure
side, automatic budget cuts will be activated, cutting expenditure
by $98 billion. Together these actions amount to a downward adjustment
in aggregate demand of no less than 4 per cent of GDP. In the worst
case, political gridlock would prevent Congress from reaching any
agreement, leading to a full-scale drop in government spending by
about $98 billion and substantial hikes in taxes amounting to $450
billion in 2013.
["It is reasonable to assume that after realizing the costs to
the economy, policymakers will feel compelled to reach an agreement
on reinstating those tax reduction measures and on ceasing the automatic
spending cuts in the second half of 2013", said the UN.]