Statement on Monetary Policy – August 2009
International and Foreign Exchange Markets
Conditions in global credit markets have continued to improve in recent months, as demonstrated by a further narrowing of spreads across most markets and a substantial increase in issuance. In money markets, spreads between LIBOR and the expected cash rate for the major currencies have narrowed considerably as counterparty concerns have abated. These spreads have fallen below levels prevailing before their sharp rise in September 2008 at the time of the Lehman Brothers default (Graph 16). However, the reduction in perceived bank counterparty risk has not yet resulted in a turnaround in cross-border bank lending, which was the component of international capital flows that contracted most sharply in 2008 (Box C).
Credit default swap (CDS) premia have also declined over recent months. In particular, premia for US financials declined substantially following the release of the US stress test results in May (see below), indicating that markets viewed the assessment as positive and the required capital raisings manageable. The gross notional amount of outstanding CDS has levelled out over 2009 after contracting sharply in the second half of 2008, in part because of efforts to reduce operational risks and capital charges through voluntary multilateral terminations. Since the beginning of 2009, there has also been some reduction in the net notional amount outstanding, which is a better measure of exposures to the underlying assets if there are no counterparty defaults.
In the United States, spreads between yields on housing agency debt and US Treasuries have narrowed since the Fed announced its plans to purchase agency debt in November, to be lower than they were prior to the crisis (Graph 17). The issuance of mortgage-backed securities (MBS) has steadily increased over the year to date, although the vast majority of this has been issued by the housing agencies and purchased by the Fed (see below).
Longer-term US non-financial corporate bond spreads have narrowed substantially across the rating spectrum to be well below the peaks seen in the aftermath of the collapse of Lehman Brothers (Graph 18). Non-financial corporations have continued to issue substantial amounts of debt in both the United States and Europe and the share of sub-investment grade issuance has risen.
Financial institutions have continued to issue bonds under their respective government-guarantee programs, although there has been much less issuance than in the first quarter. The share of European and Australian guaranteed bond issuance in the global total has increased as issuance under the US and UK programs has fallen significantly. This is particularly notable in the United States where, as discussed below, a demonstrated ability to issue unguaranteed debt is one of the preconditions for repaying Troubled Asset Relief Program (TARP) funds (Graph 19). Spreads between yields on government-guaranteed bonds and those on government securities of equivalent maturity have narrowed slightly in the United States, but have narrowed substantially in Europe and the United Kingdom. In a further sign of improving conditions, higher-rated unguaranteed bonds are being issued at spreads similar to those under the guaranteed programs, after fees are taken into account.
Central bank policy
Central banks in both developed and emerging economies have delivered a substantial easing in monetary policy over the past year by lowering policy rates (Table 2). In a number of developed economies, central banks have indicated that policy rates are effectively at their lower bound and have stated that they are expected to remain there for some time. In some cases, including the Federal Reserve, the Bank of Japan (BoJ), the Bank of England (BoE) and the Swiss National Bank (SNB), central banks have further eased their monetary stance by purchasing various financial assets and have expanded their balance sheets considerably. Notwithstanding the current very expansionary stance of policy, financial market pricing suggests that policy rates are not generally expected to begin increasing until at least early 2010.
In the United States, the Fed has eased monetary policy through outright purchases of US Treasuries, agency MBS and agency bonds. To date, the Fed has acquired over US$220 billion in US Treasuries, US$540 billion in agency MBS and US$100 billion in agency bonds, and is well on the way to achieving its targets of purchasing US$300 billion, US$1.25 trillion and US$200 billion of these assets, respectively, by the end of this year. These operations have resulted in mortgage rates being lower than would otherwise have been the case (Graph 20).
The ongoing improvement in credit market conditions has resulted in a gradual easing in the demand for funds through the Fed’s various liquidity facilities such as the Term Auction Facility and the US dollar swap facility with other central banks. For example, the balance on the swap facility with the Reserve Bank of Australia has fallen to zero, from its peak of US$27 billion in November 2008. In addition, there has been a gradual unwinding of facilities aimed at improving the functioning of commercial paper markets and demand for funds through the Term Asset-backed Securities Loan Facility remains modest, despite an extension of eligible collateral to include commercial MBS and securities backed by insurance premium finance loans. As a result, the overall size of the Fed’s balance sheet is little changed since the beginning of 2009 (Graph 21), with the increase in securities held outright being largely offset by the fall in the amount outstanding under the other facilities.
The European Central Bank (ECB) lowered its policy rate to 1 per cent at its May meeting, taking the cumulative reduction to 325 basis points since its easing phase began in October 2008. In June, the ECB conducted its first 12-month refinancing operation, providing all the funds demanded (€442 billion – the largest injection since the financial crisis began) at a fixed rate of 1 per cent. Following the settlement of this operation, the effective overnight rate in the euro area fell from around 1 per cent to around 0.4 per cent, where it has remained. The ECB also began outright purchases of euro-denominated covered bonds; it plans to purchase €60 billion of highly-rated covered bonds that are currently eligible for use as collateral in market operations by June 2010 through both primary and secondary markets. Spreads on covered bonds narrowed noticeably following the ECB’s announcement and new issuance has resumed, having all but ceased since October.
The BoJ has continued its outright purchases of Japanese government bonds, commercial paper and corporate bonds as a means of easing monetary conditions. It has also purchased a small amount of stock in financial institutions and begun small-scale operations to provide subordinated loans to financial institutions in an effort to preserve their capital bases. The BoJ has also expanded its list of eligible collateral to include foreign currency-denominated sovereign bonds including US Treasuries, gilts and Bunds.
In an attempt to further ease strains in financial markets and boost nominal economic activity, the BoE increased its target for unsterilised asset purchases by £50 billion to £125 billion and achieved this higher target by the end of July. To date the majority of asset purchases have involved gilts, however, in late July the BoE announced that it would also acquire asset-backed commercial paper in both the primary and secondary markets as part of the broader £150 billion Asset Purchase Facility.
The SNB has continued to ease monetary conditions through its purchases of private sector bonds and foreign exchange, with the latter having the publicly stated intention of preventing an appreciation of the Swiss franc against the euro. Elsewhere in Europe, Sveriges Riksbank and the Central Bank of Norway lowered their policy rates by 25 basis points in July and June, respectively, taking the cumulative change in their policy rates since the easing phase began in October 2008 to 450 basis points. Sveriges Riksbank indicated that it expects its policy rate to remain at ¼ per cent until at least mid 2010. Similarly, the Reserve Bank of New Zealand and Bank of Canada have reiterated their commitment to keep policy rates around their current low levels until the second half of 2010.
Central banks in many emerging market economies have continued to lower their policy rates (Table 3). In recent months, the cumulative easing has been particularly large in Brazil, Chile, Mexico, Russia and Turkey, but a considerable amount of stimulus has also been delivered in other countries since they commenced their easing phases.
Government financial policy actions
Governments have responded to the current crisis with policy initiatives to support and restructure financial systems. However, with the recent improvement in credit markets and financial markets more generally, there has been a noticeable shift in focus away from crisis management toward putting in place longer-term regulatory reforms. Reflecting this, authorities in the United States, United Kingdom and European Union have proposed initiatives aimed at improving policy makers’ ability to effectively supervise and regulate financial systems, including:
- the introduction of councils of financial regulators to help identify emerging systemic risks and improve interagency cooperation;
- strengthening the capital, liquidity and risk management requirements for institutions that pose systemic risks;
- in the United States, extending the Fed’s regulatory responsibility to all systemically important institutions and payment, clearing and settlement systems;
- in the United Kingdom and European Union, providing regulators with more power to ensure that remuneration practices do not encourage excessive risk taking; and
- more comprehensive regulation of over-the-counter (OTC) derivatives markets. To this end, proposed legislative changes in the United States will require all ‘standardised’ OTC derivatives to be cleared through regulated central counterparties and will subject all large market participants to prudential supervision and reporting standards. Similar changes to the CDS market are being implemented in Europe, with a number of major industry participants in the OTC derivatives market having commenced the use of a central counterparty clearing house for standardised CDS.
In May, US authorities announced the results of the stress tests designed to determine if the major US financial institutions are adequately capitalised. The tests found that 10 of the 19 banks examined needed to raise a total of US$75 billion in common equity capital to meet target capital adequacy ratios by the end of 2010 (Graph 22). Although these banks were given until November to implement a capital plan, most have already implemented or announced measures that allow them to achieve their target. Nonetheless, the US Treasury stands ready to provide funds if banks are unable to raise them from private investors.
The majority of the US banks subject to the stress tests were able to raise unguaranteed debt and access public equity markets after the announcement of the results, reflecting the improved confidence in the financial sector. This fulfilled two pre-conditions for repaying funds provided under the TARP. As a result, 10 banks have repaid their obligation to the US Government, although a number of second- and third-tier banks have received further injections of TARP funds.
In July, the US Treasury announced details of a scaled-down version of the legacy securities component of the Public-Private Investment Program first proposed in March. Nine asset managers were appointed to purchase commercial MBS and non-agency residential MBS issued prior to 2009 with an initial credit rating of AAA. These purchases will be funded by US$30 billion from the US Treasury and at least US$½ billion from each of the private managers.
The housing agencies Fannie Mae and Freddie Mac reported first-quarter losses of around US$23 billion and US$10 billion, respectively. This resulted in further capital injections of senior preferred stock from the US Treasury as part of the terms of their conservatorship, taking the total contributions to around US$34 billion and US$51 billion, respectively.
Auto makers Chrysler and GM emerged from bankruptcy protection in June and July, respectively. Chrysler was restructured and acquired by Fiat. GM’s restructure reduced its overall obligations by over US$40 billion and resulted in the US and Canadian Governments owning around 72 per cent of the common stock, while a further 18 per cent stake is owned by the UAW Retiree Medical Benefits Trust. The remaining 10 per cent stake accrued to existing bond holders in a debt-equity swap.
Regulators in the European Union announced that they will conduct EU-wide stress tests on banks using common scenarios, but that the results will remain confidential. Ahead of this, a number of European governments have provided further support to their financial sectors in recent months. In particular, the German Government has approved a scheme to create institution-specific ‘bad banks’ that will purchase impaired assets from banks in return for government-guaranteed bonds. The Russian Government is planning to inject around US$15 billion into its banking sector in light of a significant increase in non-performing loans, while the Icelandic Government announced a US$2 billion re-capitalisation of the three new banks created following the collapse of the main Icelandic banks in October 2008.
Sovereign debt markets
Longer-term bond yields in Germany, Japan, the United Kingdom and the United States have generally increased since the beginning of 2009 due to the more positive tone of economic data and related strength in equity markets (Graph 23). Concerns about the prospective large increase in supply resulting from the need to finance large fiscal stimulus packages have also contributed to rising longer-term yields at times.
In contrast, yields on shorter-term bonds have been held down by market expectations of policy rates remaining at historically low levels for some time. Consequently, yield curves for sovereign debt have steepened: the difference between yields on 10-year US government bonds and the federal funds rate is around historically high levels (Graph 24).
In Europe, the spread between yields on Irish and German government debt widened after Ireland’s sovereign credit rating was downgraded by one notch by both S&P and Moody’s due to rising public debt burdens and vulnerability to external factors. Spreads on other European sovereign debt were little changed although spreads on Greek sovereign debt continued to narrow from their peaks in the first quarter of 2009, notwithstanding the fact that Fitch placed the country’s sovereign credit rating on negative watch.
Spreads of emerging market US dollar-denominated debt to US Treasuries have fallen sharply since their recent peaks of October 2008 (Graph 25). Although there have been a number of sovereign downgrades in emerging Asia and emerging Europe, rating agencies have also made several positive announcements: Moody’s recently upgraded the long-term foreign- and local-currency debt ratings of the Philippines and reviewed Brazil for a possible credit upgrade citing its resilience to the global crisis, while S&P is considering Mexico for a possible credit upgrade. The IMF approved a US$10.5 billion short-term credit line to Colombia, which follows earlier approvals for similar assistance to Mexico and Poland.
Global equity markets have risen to be almost 50 per cent above the lows posted in early March this year (Table 4). Share prices have been supported by more positive macroeconomic data in the United States and China, the associated rise in commodity prices and more optimism surrounding the prospects for the financial sector. Second quarter earnings have generally been better than expected for US and European financial institutions: investment banking operations accounted for a significant proportion of profits while more traditional banking operations continue to report losses or substantially reduced income. Although investor sentiment remains fragile, volatility in equity markets has continued to decline although it remains above its long-run average.
Emerging market equities, with the exception of China, continue to broadly track those of developed markets, but with more sensitivity to changes in risk appetite and commodity prices (Graph 26). Over the past few months, emerging European share prices have generally suffered from a decline in investor risk appetite triggered by a failed government debt auction in Latvia in June. In contrast, Chinese stock markets have continued to rally on the back of positive economic data and are around 100 per cent above their trough in November 2008.
The recovery in equity markets this year has supported a pick-up in the performance of global hedge funds. Funds recorded an average return of 9 per cent in the June quarter, but over the year to June made an average loss of 10 per cent. Funds with large exposures to emerging markets achieved the highest returns in the June quarter, although funds with strategies based around the outlook for the global economy have fared best since early 2008. Investor redemptions slowed in the June quarter following large outflows in the previous two quarters. The recent pick-up in returns and slowing in redemptions saw total investor capital under management in the industry increase marginally in the June quarter, but it is still 25 per cent below the peak prior to the collapse of Lehman Brothers (Graph 27).
Developments in foreign exchange markets have been largely consistent with changes in general financial market sentiment. Overall, volatility in foreign exchange is well below the peaks seen late last year but nonetheless remains above average.
The US dollar has depreciated against most currencies since its recent peak in March (Table 5). Much of this movement occurred over May as risk appetite improved on better-than-expected global economic data and equity markets rallied. Several other factors also placed downward pressure on the US dollar during this period, including discussion about the long-term viability of the US dollar as a reserve currency, the downgrade of California’s credit rating and the unwinding of expectations that the federal funds rate would increase before year end. In trade-weighted terms, the US dollar is now 14 per cent below its March peak and 8 per cent lower than it was three month ago against major currencies.
Consistent with these developments, the euro appreciated against the US dollar throughout May and early June although it has been little changed since then (Graph 28). The British pound appreciated against both the euro and the US dollar reflecting better-than-expected data, despite the BoE’s decision in June to expand its quantitative easing program and S&P’s announcement that the outlook for the United Kingdom’s AAA sovereign debt rating was less certain. The Japanese yen has also appreciated against the US dollar although it has depreciated against most other major currencies, reflecting the general improvement in risk appetite.
The Swiss franc depreciated against both the euro and the US dollar after the SNB intervened in the foreign exchange market to ease monetary conditions and prevent the franc from appreciating against the euro. The Swedish krona depreciated significantly against the euro over May and June, primarily as a result of the Swedish banks’ exposure to the Baltic economies, especially Latvia. During this period, Sveriges Riksbank announced that it was increasing its foreign reserves and activated €3 billion of a €10 billion swap line with the ECB to potentially assist the Swedish banks in meeting euro funding needs. In July, the krona more than reversed this depreciation following stronger-than-expected economic data.
The continued rise in commodity prices to levels last seen around November 2008 has contributed to an appreciation of the currencies of commodity-exporting economies, including Australia (see below), Brazil, Canada, Chile, New Zealand and South Africa (Graph 29).
Currencies of the emerging Asian economies also generally continued their appreciation, which began in March as global growth prospects improved. The Indian rupee appreciated sharply on the result of the country’s general election in May. In contrast, emerging European currencies were mixed against the euro. Speculation of an imminent devaluation of the Latvian lats, which is pegged to the euro, intensified after the failed debt auction by the Latvian Government in June and led to a broad-based depreciation of emerging European currencies against the euro, even as sentiment improved in other emerging markets. Expectations that the IMF and the European Commission would release the next tranches of their assistance packages to Latvia then saw the lats appreciate to the top of its trading band by mid June, with most emerging European currencies following suit. The Polish zloty has also been supported by official comments suggesting that Poland may begin the euro-adoption process this year, as well as the World Bank’s approval of a US$4.5 billion loan. The Russian ruble depreciated sharply in mid July after the central bank unexpectedly lowered its policy rate but this was retraced as oil prices recovered. The non-deliverable forwards market indicates that the ruble is expected to depreciate over the next year.
The Australian dollar has generally appreciated since March, reaching its highest level since last September (Graph 30, Table 6). On a trade-weighted basis the Australian dollar has appreciated by 22 per cent from the trough in early March and is now 12 per cent above its post-float average. The appreciation in the currency continues to be underpinned by the pick-up in commodity prices and by the general improvement in global investor sentiment. Most of the appreciation has occurred during offshore trading when global developments, rather than Australian developments, tend to influence exchange rate movements. Consistent with this, the correlation between daily changes in the exchange rate and US equity prices, which are also influenced by changes in investor risk appetite, remains high.
The recent appreciation in the currency has allowed the Bank to replenish the foreign exchange reserves used late last year during its intervention to provide liquidity to the foreign exchange market.
Volatility in the exchange rate of the Australian dollar against the US dollar, as measured by the intraday range, has continued to fall from its peak in late 2008, but remains well above the long-term average (Graph 31). Measures of liquidity in the inter-bank foreign exchange market are currently around levels seen prior to the collapse of Lehman Brothers.