Statement on Monetary Policy – February 2008
International and Foreign Exchange Markets
There has been ongoing turbulence in international financial markets since the last Statement, including a large correction in global equity prices. The turbulence has been underpinned by two main factors: further adverse news of substantial sub-prime related losses at financial institutions and growing pessimism among investors about the outlook for the US economy and, by extension, for global growth.
The decline in sentiment in global financial markets has had much to do with the steady stream of poor fourth-quarter results from the major international banks. These have revealed further substantial credit related write-downs, mainly for sub-prime exposures, which in some cases have led to large losses. Data for the third quarter show that sub-prime delinquencies have risen above their previous cyclical peak, with most estimates pointing to a further sharp rise in the fourth quarter (Graph 13).
Since the onset of the crisis, the major banking institutions have announced around US$125 billion of sub-prime related write-downs. At the same time, their capital position is being stretched by the need to take onto their balance sheets around US$120 billion of assets previously held in off-balance-sheet vehicles. The capital of banks is also being constrained by their need to retain loans on their balance sheets that would have previously been on-sold into structured finance and syndicated loan markets. These markets have remained largely closed.
Reflecting these developments, some of the major banks have sought sizeable capital injections in the order of US$75 billion, primarily from Asian and Middle Eastern sovereign wealth funds. These equity injections have returned capital ratios to their pre-crisis levels.
Concerns are continuing to mount about the prospects for the US ‘monolines’ – specialised companies that provide insurance against losses on credit instruments. These companies are an important source of credit enhancement in global bond markets, often allowing bonds that would otherwise have a lower investment-grade rating to achieve the highest possible rating. They are estimated to have insured around US$2.3 trillion of debt, of which more than half is public debt including municipal bonds.
The capital of monolines is being depleted by losses on mortgage-related debts, jeopardising the high credit ratings that they need to stay in business. If their ratings are cut, the rating of the bonds they insure may also be reduced. The ratings of Ambac and FGIC, the second and fourth largest monolines, were cut by Fitch from AAA to AA after both failed to meet the agency’s deadline to raise US$1 billion in capital. Concern about monolines has led some banks to provision or write off their insurance exposures to these companies.
A major challenge for central banks in the run-up to the year end was the elevated level of short-term interest rates as financial intermediaries hoarded liquidity (Graph 14). In an effort to ease term funding pressures, the US Federal Reserve, the European Central Bank (ECB), the Bank of England (BoE), Bank of Canada (BoC) and Swiss National Bank launched co-ordinated money market operations. In particular, the Fed introduced a ‘term auction facility’ to make funding of terms up to 35 days available to all depository institutions rather than just the limited group of primary brokers that can participate in its routine lending operations. The ECB and the Swiss National Bank also made US dollars available to European banks, with a total of US$48 billion provided at auction. These measures, along with the passing of year-end funding pressures, have seen spreads in interbank lending markets fall markedly since mid December.
Some positive signs are also evident in other funding markets. In particular, the asset-backed commercial paper (ABCP) market started growing again in December following several months of sustained decline (Graph 15). Issuance in US corporate debt markets also rebounded somewhat in January, to more than US$65 billion from less than US$45 billion in the previous two months.
Official policy rates
Since the previous Statement, the US Federal Reserve and a number of other developed country central banks have eased monetary policy, as they have assessed that the implications of the financial sector difficulties for growth have outweighed inflation concerns (Table 2, Graph 16). However, some major central banks have opted to keep their rates unchanged due to persistent inflationary pressures and policy has been tightened in a number of emerging-market economies, where inflation pressures continue to build.
In the United States, the Federal Open Market Committee (FOMC) cut its policy rate by a cumulative 150 basis points in three moves over December and January, including an inter-meeting cut of 75 basis points. The unscheduled inter-meeting move followed very sharp falls in global equity markets on 21 and 22 January. The easing came as the Fed acknowledged that the weakness in the housing market was likely to see growth slow significantly this year. The market now expects the Fed funds rate to fall by 100 basis points over the next six months to 2 per cent.
In contrast, inflationary concerns have led the ECB to maintain its policy rate at 4 per cent, judging the downside risks to growth posed by recent financial developments to be offset by the upside risks to inflation. The Bank of Japan also left its policy rate unchanged at ½ per cent.
The BoE lowered its policy rate by 25 basis points in December to 5½ per cent, but left it unchanged at its January meeting. In Canada, the policy rate was lowered by 50 basis points to 4 per cent, with cuts in December and January. The BoC judged that increased downside risks from a slower US and global economy outweighed the upside risks to inflation from a strong domestic economy operating above its production capacity.
In contrast, the Norges Bank increased its policy rate by 25 basis points to address inflation concerns. Rates were kept on hold in Sweden and Switzerland, at 4 per cent and 2¾ per cent respectively (Graph 17). The Reserve Bank of New Zealand also kept its policy rate on hold at 8¼ per cent, citing ongoing inflationary pressures.
Strong growth and increased inflationary pressures remain a significant concern for a number of emerging-market economies. In China, authorities are seeking to contain inflation, which is currently around 6½ per cent. The People’s Bank of China raised its 1-year lending rate and 1-year deposit rate in December (Graph 18). This marked the sixth increase since the start of 2007, leaving policy rates at nine-year highs. The required reserves ratio was also raised three times since the previous Statement, with the increases totalling 200 basis points.
In other emerging markets, policy rates were raised in a number of countries to combat inflation pressures including: South Africa, Chile, the Czech Republic, Poland, Israel and Taiwan. In contrast, policy rates were cut in Indonesia, the Philippines and Turkey.
There have been some sharp movements in major market government bond yields since the last Statement, withdaily volatility at its highest level in a number of years. US bond yields have traded in an 85 basis point range over the period, but have ended markedly lower amid ongoing concerns about global credit markets and the weaker US economic outlook (Graph 19). Yields on 2-year debt have declined by over 150 basis points.
German and Japanese bond markets have largely taken their lead from the US since the last Statement, although the overall decline in yields has been less pronounced. As a result, the spread between German and US 10-year yields has widened to around 30 basis points.
Moody’s global speculative-grade default rate continued to fall in December, down by 10 basis points to 0.9 per cent, the lowest default rate since December 1981 (Graph 20). However, Moody’s is forecasting a sharp rise in defaults to around 5 per cent by December 2008 on expectations of weaker economic conditions in the US. Consistent with the worsening outlook, credit spreads for speculative grade debt have widened by around 200 basis points as investor appetite for high-risk, high-yield debt has diminished (Graph 21). However, a significant part of this move has reflected the decline in US Treasury yields. Borrowing costs for highly rated corporates are little changed or have even fallen in recent months. Spreads on emerging-market sovereign debt have also continued to widen but again this largely reflects the decline in US Treasury yields, with borrowing costs for emerging Asian and Latin American sovereigns largely unchanged (Graph 22).
There has been a fall in global equity prices since the previous Statement (Graph 23). The decline has been broad-based across sectors and markets (Table 3). There were particularly sharp falls in mid January, although markets pared back some of those losses following the Fed’s unscheduled rate cut. In the US, the sub-prime write-offs saw financial sector share prices fall to levels last seen in 2003, while the broader market reached lows around its late 2006 level.
After remaining relatively immune to the risk retrenchment which took hold in major markets in the second half of 2007, shares in emerging markets have fallen sharply in the latest bout of turbulence. Nevertheless, Asian and Latin American markets have still posted solid gains over the past year.
Foreign exchange markets have been volatile in recent months, as the flow of negative credit news and economic data has generated large shifts in market sentiment. On a trade-weighted basis, the US dollar has moved modestly higher since the last Statement (Table 4), though it still remains around its lowest level in over 30 years (Graph 24). This reflects a continued depreciation of the US dollar against the yen (Graph 25), offset by appreciation of the dollar against some other major currencies, notably the Canadian dollar and UK pound. Heightened risk aversion and the liquidation of yen carry-trade positions in high-yield currencies saw the yen appreciate sharply in January, pushing the yen to its highest level against the US dollar since around mid 2005.
The Chinese renminbi has appreciated against the US dollar since the last Statement (Graph 26) at its fastest pace since the revaluation in mid 2005. Against the dollar, the Chinese currency has now appreciated by around 13 per cent since its revaluation, but has appreciated more modestly on a trade-weighted basis. Pricing in the non-deliverable forwards market suggests that the renminbi will appreciate by around 9 per cent over the next year.
The Australian dollar has traded in a large range in the period since the last Statement. Movements over the past few months have been largely driven by shifts in market risk appetite, with the correlations between Australian dollar crosses and US equity markets, for example, currently at very high levels (Graph 27).
Australian dollar volatility has declined after spiking in November, although it remains above its long-term average. Moreover, since the beginning of January the Australian dollar has traded in an average daily range of around 1¼ cents, reflecting the substantial intraday movements that continue to be recorded in both directions (Graph 28).
In recent months, the Australian dollar has depreciated against most major currencies, particularly the yen and the Swiss franc (Table 5). However, the strong domestic economy and relatively high Australian dollar yields have provided support. Looking through recent fluctuations, the Australian dollar has appreciated in trade-weighted terms over the past year and is still well above its post-float averages (Graph 29).
Reflecting the decline in sentiment towards the Australian dollar following developments in global credit markets, as well as year-end position squaring, net long speculative positions in Australian dollar futures at the Chicago Mercantile Exchange have been unwound since the previous Statement.
The Bank has made net foreign exchange purchases of around $420 million since the previous Statement. As a result, net reserves have risen from their end-October levels, and now stand at $363/4 billion. The Bank’s holdings of foreign exchange under swap arrangements have been markedly reduced in recent months. As discussed in Box A, this has occurred for two reasons: to accommodate the shift in domestic operations towards bank bill repurchase agreements that began during the recent turmoil in credit markets, as well as the reduction in the overall balance sheet. This process has now run its course with the foreign exchange swap book around zero.