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
"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
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
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
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
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
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
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
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
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
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. +