Statement on Monetary Policy – May 2008
International and Foreign Exchange Markets
Sentiment in financial markets has fluctuated considerably since the last Statement. It deteriorated markedly in February and March as banks tightened or withdrew funding to highly leveraged investors, triggering the forced sale of assets. Confidence reached its nadir when Bear Stearns, the fifth largest Wall Street securities firm, had to seek substantial emergency funding from the US Federal Reserve and was ultimately sold to JPMorgan. However, the Fed’s action with regard to Bear Stearns helped stabilise markets. Since then there has been some further improvement in market sentiment as a number of financial institutions have successfully raised capital following a further round of write-downs of impaired credit exposures.
Credit and money markets
The current credit crisis has its origins in the poor performance of securities backed by US mortgages, particularly sub-prime mortgages. Reflecting this, the ongoing deterioration in the US housing market continues to weigh on financial markets. Data for the fourth quarter released since the last Statement show a further sharp rise in delinquency rates for sub-prime mortgages, while delinquencies on prime loans also reached multi-year highs (Graph 14). Delinquencies on mortgages originated in 2006 are notably higher than those on earlier vintages, while those on 2007 mortgages already appear to be higher again (Graph 15). This suggests that delinquencies in aggregate still have some way to rise. Credit default swap prices1 suggest that the market value of lower rated sub-prime residential mortgage-backed securities (RMBS) has continued to decline over recent months, though prices for the highest-rated instruments appear to have stabilised.
The decline in value of mortage-related assets, along with the decline in the value of other credit-related asset classes, has seen major global banks report write-downs for the first quarter of around US$100 billion (Table 2). This takes total write-downs since August to around US$280 billion. In addition, reflecting the turn in the broader credit cycle, banks have increasingly set aside larger provisions for a more generalised deterioration in asset quality.
In response to these losses, international banks have announced new capital raisings also totalling around US$100 billion in recent months. Many of these new capital raisings were secured or underwritten before public announcements were made, which appeared to contribute to the improvement in market sentiment in April. Many institutions also cut dividend payments to preserve capital.
In a number of instances public funds have been employed to support troubled institutions, the most prominent being Bear Stearns. The Federal Reserve announced mid March that it had provided emergency funding to Bear Stearns through JPMorgan. This followed a rapid withdrawal of client funds over several days of intensifying market rumours about the investment bank’s solvency. Subsequently, as part of a rescue package, the Fed agreed to provide US$29 billion in financing for the ‘less-liquid’ assets on Bear Stearns’ balance sheet for a term of 10 years which helped facilitate the acquisition by JPMorgan of the failed investment bank. JPMorgan has committed to honouring all Bear Stearns’ liabilities and will incur the first US$1 billion in the event of loss on the assets funded by the Fed. In the United Kingdom, Northern Rock was taken into public ownership in February after the government rejected inadequate bids from the private sector. In Germany, the government has pledged an additional US$2.2 billion to IKB Deutsche Industriebank in its third assistance package since last year.
The heightened market strains around the time of the Bear Stearns rescue were evident in a number of markets. Part of the dislocation reflected forced selling by hedge funds as banks tightened their margin requirements for leveraged investors. A number of funds, including Carlyle Capital, defaulted on debt after being unable to refinance RMBS investments. These negative developments saw spreads on credit default swaps spike in mid March as the traditional sellers of credit protection, including monolines and investment banks, reduced their participation in the market (Graph 16). Spreads have subsequently narrowed considerably as market sentiment has improved, although they still remain near their highs of 2007.
Concerns have persisted around the state of the monoline bond insurers which have generally been unable to underwrite new issuance as their own credit ratings have been downgraded. One consequence of this has been that credit risk has risen on the possibility that monolines will be unable to make payments on the guarantees they have made in the past. These concerns have been associated with disruptions in municipal bond markets and issues of securities backed by student loans. Interest rates in the auction-rate bond market used by local government borrowers remain elevated as a result. Higher borrowing costs have pushed some US counties close to bankruptcy and lenders have also stopped writing some types of student loans.
Money markets and central bank operations
Conditions in key money markets have remained strained, in contrast to the improvement in most other financial markets (Graph 17). Tensions increased towards the end of the March quarter reflecting concerns about the availability of funds through that period. However, unlike in September and December when such quarter-end tensions eased soon after the event passed, this has not been the case for all markets in the most recent episode despite the general improvement in financial market sentiment. The London Interbank Offered Rate (LIBOR) for US dollars continued to rise in April amid concerns that banks were understating their borrowing costs. The British Bankers’ Association, which compiles the LIBOR, indicated that it would take action against any bank mis-quoting. US dollar LIBOR spreads have since narrowed somewhat.
The tightening in money market conditions occurred despite extensive use of new liquidity facilities introduced by the Fed and other major central banks to ease the strains in term money and repo markets (see Box A for a summary of changes to the Fed’s market operations). Central banks have been willing to provide liquidity at longer maturities, against a wider range of collateral and, in the case of the Federal Reserve, with a wider range of counterparties. However, these operations have generally not significantly increased the level of system liquidity (exchange settlement balances in the Australian case). Where liquidity has been injected at one maturity, it has generally been offset by the withdrawal of liquidity at another maturity.
The Fed and the Bank of England (BoE) have also joined the European Central Bank (ECB) in accepting a wider range of collateral, notably highly-rated mortgage backed securities, in their repurchase transactions (Graph 18). In late April the BoE announced a Special Liquidity Scheme (SLS) that would enable it to swap UK Treasury bills for mortgage-backed securities. Since the Treasury bills will be issued by the UK Debt Management Office rather than drawn from the central bank’s own holdings, this will lead to a grossing up of the BoE balance sheet, while leaving overall system liquidity unchanged. These operations are intended to remove less-liquid and lower-rated securities from the balance sheet of financial institutions at a time when market strains are making it difficult to use these assets to generate the required cash flow. Central banks also expanded their use of co-ordinated actions involving foreign exchange ‘swap lines’ between the US Federal Reserve, the ECB and the Swiss National Bank.
Official policy rates
Since the previous Statement, three major central banks have continued to ease monetary policy to address the growing downside risks to growth stemming from the ongoing disturbances in financial markets (Graphs 19 and 20). In marked contrast, inflation remains the predominant concern in a number of European countries and many emerging market economies, some of which have tightened policy in recent months.
In the United States, the Federal Open Market Committee (FOMC) lowered the policy rate by 75 basis points in March and a further 25 basis points in April, taking the cumulative policy easing since August 2007 to 325 basis points. With the size of the easing to date and a number of FOMC members signalling their concern about the outlook for inflation, the market currently expects no further easing in policy.
In the euro area, inflation concerns have led the ECB to keep its policy rate unchanged at 4 per cent. Despite acknowledging heightened uncertainty and increased downside risks to growth as a result of financial market disruptions, the ECB continued to emphasise inflation risks posed by potential second-round effects stemming from elevated energy and food prices. With the focus on the upside risks to medium-term inflation, markets have pared back earlier expectations of policy easing, such that no change is expected in the policy rate for the coming half year.
The Bank of Japan (BoJ) also kept its policy rate on hold at ½ per cent. Nonetheless, the BoJ’s assessment of the economy has deteriorated over the past three months, with growth seen to slow as a result of higher input costs. No change to the policy rate is expected by the market in coming months.
In the United Kingdom, the BoE reduced its policy rate on two occasions since the previous Statement, each time by 25 basis points (Graph 20). In the accompanying statements and minutes to the decisions, the BoE judged the downside risks posed by market disruptions in the UK financial system to outweigh upside risks from higher energy and food prices. The market expects policy to be eased by a further 25 basis points over the next six months. Similarly, the Bank of Canada cut its policy rate twice by a cumulative 100 basis points to 3 per cent since the previous Statement. The market currently expects two additional rate cuts of 25 basis points each.
Elsewhere, growing inflation concerns in Sweden and Norway have led the central banks to increase their policy rates by 25 basis points to 4¼ per cent and 5½ per cent respectively. Policy rates remained unchanged in Switzerland at 2¾ per cent.
The Reserve Bank of New Zealand (RBNZ) left its policy rate unchanged at 8¼ per cent. In the accompanying statements, the RBNZ acknowledged increased uncertainty, with economic activity having slowed more rapidly than expected, while inflation remains elevated. No change in rates is anticipated over the coming months.
For many emerging market economies, inflation has continued to be the dominant concern amidst further increases in energy, commodity and food prices. The People’s Bank of China raised its reserve requirement ratio for banks by a cumulative 100 basis points to 16 per cent as inflation remained near its 11-year high (Graph 21). The latest move marked the third increase in the ratio this year, with the cumulative increase since 2006 amounting to 850 basis points. The central bank of India has also raised its reserves ratio several times since the last Statement. A worsening inflation outlook led the central banks of Indonesia, Taiwan, the Czech Republic, Hungary, Poland, Russia, Brazil and South Africa to raise their policy rates. Similar concerns have led the Monetary Authority of Singapore to shift its currency trading band upwards to slow the pace of inflation, which reached a 26-year high in February. In contrast, the central banks of Turkey and Israel both eased policy rates over the period amidst concerns of a slowdown in trading partner growth.
Over the past three months there has been considerable volatility in US government bond yields, particularly at shorter maturities (Graph 22). US bond yields traded in a 60 basis point range over the period. In mid March, 10-year yields fell to their lowest level since mid 2003 as general economic and credit market concerns were heightened by news of the Fed‑assisted takeover of Bear Stearns. Yields subsequently recovered in April as financial market sentiment improved.
The spread between German and US 10-year yields widened to be the highest since end 2002, reflecting the contrasting developments in the two economies. De-leveraging among a number of highly geared institutions resulted in some dislocation in secondary European sovereign debt markets in mid March (Graph 23). Relative to German government bonds, the spread of sovereign bonds in Italy, France, Spain, and the Netherlands widened significantly. These spreads had previously amounted to no more than a few basis points.
With credit market disturbances evident in March, investor appetite for high-yield debt diminished, raising spreads on corporate debt to highs not seen since 2002 (Graph 24). However, only the level of the more risky corporate yields with most exposure to the economic cycle and funding pressures has risen noticeably since the middle of 2007.
Corporate bond issuance in the US remained low in the March quarter, particularly for non-financial companies who resorted to other sources for funding. However, issuance picked up in April, led by financial corporations. The ability of institutions to issue new debt for funding, as well as replenish their capital positions following substantial write-downs, has been a key factor in shoring up financial market sentiment in recent weeks.
The yield on sovereign debt in emerging Asia, Europe and Latin America has moved little since the middle of last year, and there have been no major developments since the last Statement (Graph 25). The spread on emerging market debt has been almost exclusively driven by movements in US government bond yields.
There has been a modest recovery in global equity markets since the last Statement, though volatility remains elevated (Table 3). The stock price of financials fell sharply due to concern over the availability of funding amid the deterioration of liquidity in the banking system (Graph 26). These strains peaked in mid March when Bear Stearns sought emergency funding. Since then, the release of first-quarter earnings reports has seen a recovery in share prices despite major financial institutions announcing more write-downs on credit instruments. Investor sentiment appears reassured by announcements that banks have been able to raise additional capital despite difficulties in several key markets. Broader global equity markets have also been supported by gains in energy and material sector stocks, following renewed strength in oil and commodity prices.
Better-than-expected profit reports for non-financial corporates in the US have seen earnings rise by around 10 per cent from the same period a year ago. Positive surprises have outnumbered unexpectedly poor results, suggesting that the slowdown in economic activity to date has had less impact on earnings than investors had previously feared.
Emerging market share prices have generally recovered somewhat from their lows earlier in the year. The exception has been China, where shares have fallen on concern that interest rates may have to rise significantly to contain inflation. Renminbi denominated China-A shares are down around 40 per cent since their peak in October 2007, prompting local authorities to cut transaction taxes in an effort to stem the decline.
The major development in foreign exchange markets in the period since the last Statement is the continued depreciation of the US dollar against most other major currencies (Table 4). On a nominal trade-weighted basis the dollar reached a three-decade low, while the real effective exchange rate is close to the trough reached in 1995 (Graph 27). The dollar reached a post-war low against the euro during April before rebounding in recent weeks (Graph 28).
The Japanese yen also appreciated against the US dollar, reaching its highest level since the trough of 1995. Growing risk aversion over ongoing strains in financial markets and the state of the US economy resulted in an unwinding of carry trade positions. This was reflected in an increase in the volatility of low-yielding currencies such as the Japanese yen and Swiss franc. As the de-leveraging process progressed, the Swiss franc exceeded parity against the dollar for the first time. However, the improvement in sentiment towards the US dollar in April has seen the dollar pare back losses against these low interest rate currencies.
Emerging market currencies have been mixed against the US dollar (Graph 29). The Chinese renminbi continued its slow but steady appreciation against the US dollar. Pricing in the non-deliverable forward market indicates that the market currently expects the renminbi to appreciate by a further 8 per cent over the next year. The Brazilian real appreciated after interest rates were raised for the first time in around three years. The Singapore dollar gained after the central bank raised the trading range on the currency. In contrast, the South Korean won depreciated sharply against the dollar, as foreign investors sold equities on general risk aversion and concerns the slowdown in the US will dampen external demand.
The Australian dollar has appreciated against most major currencies since the last Statement, reaching a 24‑year high against the US dollar of just under 95½ cents in April (Graph 30, Table 5). The appreciation reflects both the broad-based US dollar depreciation and a general increase in investor risk appetite, although the currency remains sensitive to developments in global financial markets, particularly equity markets. This is reflected in the continued high correlation between the Australian dollar and equity market indices (Graph 31). On a trade-weighted basis, while rising by 5 per cent since the last Statement, the Australian dollar is still below the multi-year highs reached late last year.
Over the past 3 months, the Australian dollar has also been supported by strong commodity prices, including the announcement of higher contract prices for iron ore and coal, which led to expectations of a strong increase in the terms of trade in 2008. As has been the case in recent years, positive interest rate differentials and strength in the local economy also provided support. These factors have attracted private capital inflow, although this slowed noticeably in the second half of 2007 (the most recent data available), largely reflecting the turmoil in global financial markets.
Australian dollar volatility increased in March, but remained below the peaks reached in late November 2007. Since then, volatility has declined, and is now at around its post-float average. There have been substantial intraday movements in the local currency in both directions from around mid 2007. Since the last Statement, the Australian dollar has traded in an average daily range of US1.1 cents. This is modestly lower than the preceding three-month period, but still above the long-term average (Graph 32).
With the Australian dollar reaching a 24-year high against the US dollar, the Bank has continued to purchase foreign exchange. The Bank has made net foreign exchange purchases of around $660 million since the previous Statement, and net reserves now stand at around $36½ billion.
- For more details, refer to ‘Box B: The ABX.HE Credit Default Swap Indices’, RBA Financial Stability Review, March 2008, pp 18–22.