Statement on Monetary Policy – November 2009
International and Foreign Exchange Markets
Conditions in credit markets have continued their improvement that began in mid March. In money markets, spreads between LIBOR and the expected cash rate for the major currencies have narrowed substantially and are well below those prevailing throughout most of the financial crisis (Graph 17). Notably, US dollar LIBOR spreads are currently around where they were prior to the crisis. With policy rates at historically low levels in many countries, these narrower spreads imply that the absolute level of these rates is also at historic lows.
Spreads on corporate bonds issued by US financials and lower-rated (‘junk’) corporates have also continued to narrow and are at their lowest levels since mid 2008, while spreads on highly-rated debt issued by non-financials have stabilised at levels comparable to those prevailing prior to the crisis (Graph 18). In the United States, spreads between yields on housing agency debt and US Treasuries are near pre-crisis lows. Again, given the low level of government bond yields, many of these borrowing rates are also at historically low levels.
Over the past six months, aggregate corporate bond issuance has moderated in the United States (Graph 19). Similar trends are evident in Europe and the United Kingdom. Issuance by non-financial corporates in the United States has returned to pre-crisis levels, partly reflecting the relative ease with which US corporates can directly access debt markets compared with intermediated borrowing.
For financial institutions, increased issuance of unguaranteed bonds has not been enough to offset reduced guaranteed issuance. The decline in aggregate issuance by financials reflects, in part, the large volume of guaranteed issuance early in the year and reduced total funding requirements because of slower balance sheet growth. The increased issuance by financial institutions of unguaranteed bonds partly reflects the fact that it has become increasingly cost-effective: the improvement in credit market conditions has seen spreads on unguaranteed debt for many institutions decline further than spreads between yields on government-guaranteed bonds and government securities. The shift away from guaranteed debt issuance also partly reflects the determination of many major banks, particularly in the United States, to demonstrate their ability to issue unguaranteed debt and raise new capital from private sources in order to be allowed to exit various government programs.
Reflecting the decreased need for government guarantees, a number of authorities, including the Federal Deposit Insurance Corporation (FDIC), have signalled that their programs will expire as planned or will be extended to only cover institutions for which issuing unguaranteed debt remains exceptionally expensive. In the United States, the government guarantee on senior unsecured debt expired at the end of October 2009, but the FDIC will provide guarantees in exceptional circumstances for a further six months for a fee of 300 basis points. Ireland and Sweden have also extended their bank bond guarantees but, in Ireland’s case, at a higher fee.
Credit default swap (CDS) premia on bank debt and a range of other assets have also declined further in recent months, reflecting the ongoing abatement of the severe risk aversion that characterised credit markets during the worst of the crisis. CDS premia on investment-grade and more risky corporate debt such as leveraged loans have continued to fall.
While spreads on US commercial mortgage-backed securities (CMBS) have also narrowed from their peaks, their prices remain well below the levels prevailing before the Lehman Brothers default in September 2008 (Graph 20). Prices on sub-prime residential mortgage-backed securities (RMBS) have shown relatively little improvement and remain less than half their pre-crisis levels, reflecting their higher expected likelihood of default.
Central bank policy
A number of central banks have continued to ease monetary policy through lower interest rates in the case of emerging economies or outright asset purchases in the case of some advanced economies. However, the rate at which monetary conditions are being eased has slowed and the demand for liquidity offered by central banks is receding.
Central banks in most economies have lowered policy rates substantially since the beginning of their easing phases but, in many cases, rates have remained unchanged (near their lower bounds) for at least six months (Table 2). Financial market pricing suggests that policy rates in the United States and euro area are not expected to begin increasing until the middle of 2010; the Fed has indicated that it will maintain its policy rate at the lower bound for a considerable period. The Bank of Canada (BoC), Reserve Bank of New Zealand (RBNZ) and Sveriges Riksbank have also reiterated their commitments to keep policy rates around their current low levels until at least the second half of 2010. In contrast, the Bank of Israel and Norges Bank have recently raised their policy rates by 25 basis points in response to rising inflation expectations.
In the United States, the Fed has continued to ease monetary policy through outright purchases of US Treasuries, agency RMBS and agency debt. The Fed completed its program of purchasing US Treasury securities at the end of October and announced that it will slow the pace of agency RMBS and agency debt purchases by extending the completion date of this program by three months to the end of March 2010. The Fed also reduced its target for agency debt purchases from US$200 billion to around US$175 billion. To date the Fed has acquired around US$980 billion in agency RMBS, US$140 billion in agency debt and US$300 billion in Treasuries – of an ultimate target of around US$1,725 billion. These operations appear to have placed some downward pressure on mortgage rates (Graph 21), although this has had little impact on household debt servicing in the United States (see Box B).
The Bank of England (BoE), European Central Bank (ECB), Bank of Japan (BoJ) and Swiss National Bank (SNB) have also continued to ease monetary conditions through outright asset purchases:
- The BoE expanded its target for asset purchases by £50 billion to £175 billion at its August meeting, in an attempt to further ease strains in financial markets and boost nominal economic activity. The target was reached in November, as scheduled, with the majority of purchases having been gilts.
- The ECB has purchased approximately €20 billion of euro-denominated covered bonds with the aim of acquiring €60 billion of such bonds by June 2010. Purchases of these securities have helped spreads in the secondary market to fall and have supported issuance in the primary market.
- The BoJ has continued its outright purchases of Japanese government bonds, commercial paper and corporate bonds, but the ongoing improvement in corporate financing markets has resulted in the pace of commercial paper and corporate bond purchases slowing. The BoJ also continued to make small purchases of stock in financial institutions.
- 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.
Ongoing improvements in financial market conditions since March have led to a gradual decline in demand for liquidity offered by central banks. Funds outstanding through the Fed’s Term Auction Facility (TAF) and the US dollar swap facility with other central banks have returned to around pre-Lehman Brothers levels. As a result, the Fed is scaling back TAF operations while several central banks including the ECB, BoE, SNB, BoJ and Reserve Bank of Australia have wound back or ceased auctioning US dollars under swap (see ‘Box E: Normalisation of Domestic Market Dealing Operations’). In addition, there has been a gradual unwinding of facilities aimed at improving the functioning of commercial paper markets and, after increasing for a number of months, demand for funds through the Term Asset-backed Securities Loan Facility (TALF) has recently fallen. Despite this, the Fed extended asset-backed and legacy commercial mortgage-backed TALF operations to the end of March 2010. Nonetheless, the Fed’s balance sheet has expanded modestly in recent months as the fall in liquidity facilities has been more than offset by the rise in securities held outright as a result of asset purchases (Graph 22).
Demand for additional liquidity offered by the ECB has also fallen. Following the successful June operation, the ECB conducted its second 12-month refinancing operation in September, providing all the liquidity demanded at a fixed rate of 1 per cent. The amount allocated and the number of institutions participating fell significantly. The effective overnight rate in the euro area has remained around 0.4 per cent since settlement of the June operation. The BoC and RBNZ have also begun to scale back emergency liquidity facilities as conditions in financial markets improve.
Government financial policy actions
As conditions in financial systems normalise, the focus of government financial policies has shifted away from emergency measures and towards longer-term initiatives designed to support stability and improve regulatory oversight, including in financial markets such as the over-the-counter derivatives market.
Since the beginning of the year, over 100 FDIC-insured financial institutions have failed in the United States. While many more institutions failed during the Savings and Loans (S&L) crisis in the late 1980s and early 1990s, the average size of banks that failed or received assistance in the recent crisis has been much bigger and more concentrated in time (Graph 23). The FDIC announced that to replenish its deposit insurance fund, which has been depleted by bank closures, banks will be required to pre-pay the next three years of insurance premia (amounting to US$45 billion). The FDIC currently has US$22 billion in liquid assets to meet the cost of bank failures, and expects to face a shortfall in its liquid assets in the first quarter of 2010 if no action is taken. The FDIC has also extended its transaction account guarantee program by six months until end June 2010, with participating institutions subject to increased fees during the extension period. As noted above, the FDIC has amended its guarantee on bank debt.
Reflecting the normalisation in global financial market conditions, a number of US institutions have repaid their obligations to the US Government. Most notably, Bank of America agreed to pay almost US$½ billion to terminate a guarantee on a pool of assets associated with its acquisition of Merrill Lynch. However, the housing agency Fannie Mae reported second-quarter losses of around US$15 billion, resulting in further capital injections of senior preferred stock from the US Treasury as part of the terms of its conservatorship, taking the total contribution to around US$50 billion. In contrast, the housing agency Freddie Mac recorded a second-quarter profit of US$0.8 billion, leaving its total funding from the US Treasury unchanged at US$51 billion. A number of other government support programs, such as the US Treasury’s money market fund guarantee program, have been unwound over recent months.
In the United Kingdom, the Government announced changes to its financial arrangements with Lloyds and Royal Bank of Scotland (RBS). Lloyds will no longer participate in the Government’s Asset Protection Scheme (APS) in return for raising additional private sector capital and paying a fee for the implicit protection provided to date. The Government will also provide further capital, although its shareholding will stay at 43 per cent. RBS will participate in the APS under revised terms that see it bear a larger share of losses on assets covered. The Government will provide a further capital injection which will result in its voting rights increasing from 70 per cent to 75 per cent. In France, three large banks have raised debt and equity capital in order to repay their obligations to the Government.
Ireland announced further details of its bad bank program in September. The National Asset Management Agency (NAMA) will remove riskier real estate loans from banks’ balance sheets by purchasing loans with book value of around €77 billion at a discount of 30 per cent (though at an estimated 15 per cent premium to market value). The Government will provide institutions with additional capital if they are unable to raise sufficient amounts privately after transferring their impaired assets to NAMA. Most loan transfers are expected to be completed by mid 2010.
Sovereign debt markets
Shorter-term bond yields in the United States, Japan and Germany have been relatively stable over the past six months as policy rates in most economies are expected to remain low for an extended period. In contrast, shorter-term yields in the United Kingdom have tended to move lower. Longer-term bond yields have shown little net change over recent months, but remain above their troughs recorded at the beginning of the year (Graph 24). These movements have occurred alongside strength in equities and improving economic data. In Europe, spreads between sovereign debt issued by most European Monetary Union member countries and German government debt have been little changed and are well below the peaks experienced at the end of 2008. Greece is one exception, with spreads on its sovereign debt widening after Fitch downgraded it to A- from A. Fitch also downgraded Ireland’s sovereign rating by two notches, to AA– from AA+, citing concern about the Irish banking sector and fiscal position.
Spreads of emerging market US dollar-denominated debt to US Treasuries have narrowed further from their peaks reached in October last year (Graph 25). Moody’s has upgraded both Brazil and Indonesia’s sovereign credit ratings, citing resilience to the global recession, while Fitch has removed its negative outlook for South Korea and S&P has upgraded its outlook for Indonesia to positive. In a further signal of improving global financial conditions, a number of emerging economies including Brazil, Mexico, Poland and the Philippines have recently issued US dollar-denominated debt. On the other hand, S&P downgraded Latvia and Estonia, and Moody’s downgraded Lithuania, citing depressed economic conditions and the pressure that their fixed exchange rates are placing on public finances.
Major share indices reached 12-month highs in October, supported by positive macroeconomic data and improved optimism as financial sectors returned to profitability (Graph 26). Company earnings reported since the previous Statement in the United States and Europe were, on average, above expectations, most notably in the financial and information technology sectors. Japanese equity markets have underperformed in recent months: auto manufacturers and other exporters were adversely affected by the appreciation of the yen and negative earnings results.
Indicative of the significant recovery in financial markets since the lows posted in early March, financial sector earnings reports have continued to generally highlight investment banking operations as the main source of profit (Graph 27). In contrast, retail-oriented operations of financial institutions have continued to record losses or substantially reduced income, reflecting further large loan-loss provisions as a result of the poor state of the macroeconomy. Correspondingly, those banks whose operations are more heavily oriented toward investment banking, such as JPMorgan and Goldman Sachs, have posted stronger results than banks focused on retail lending, such as Bank of America.
Although there are some concerns regarding possible overvaluation, the forward-looking price-to-earnings (P/E) ratio remains broadly in line with its long-term average (Graph 28). At the same time, option-implied volatility in equity markets fell to around its long-run average in October, although it has since picked up a little.
Equity markets in emerging countries, with the exception of China, have continued to track movements in developed markets with prices reflecting positive macroeconomic data and investor sentiment. The strong rise in commodity prices has seen equity markets in Latin America and Russia outperform those in most major economies (Table 3). After rising steadily in August on positive economic data, Chinese equities fell sharply in September amid concerns that the recent rapid expansion in credit may be curtailed. Despite the fall in prices, Chinese equities have risen by over 70 per cent in the year to date, outperforming equity markets in all major economies.
Following large losses during the crisis period, hedge funds reported an average return of 7 per cent for the September quarter, partly as a result of the continued recovery in equity markets, particularly those in emerging markets. Total capital under management in the industry has picked up from the trough in the March quarter but remains around 20 per cent below the peak in June 2008 (Graph 29). The improvement in performance has seen a slowing in redemptions and a small net inflow of investor funds in the September quarter following sizeable outflows over the past year.
In general, exchange rates have followed their trends since March, broadly reflecting the ongoing improvements in financial market sentiment. The US dollar has continued to depreciate against most currencies over recent months (Graph 30, Table 4). In trade-weighted terms, the US dollar is around 15 per cent lower than its recent peak in March and only 6 per cent above its historical low in March 2008. Volatility in foreign exchange markets is well below its peak recorded late last year, although it remains above longer-run average levels.
Increases in commodity prices have contributed to an appreciation of the currencies of some commodity-exporting economies in recent months, including Australia (see below), Brazil, Canada, New Zealand and South Africa (Graph 31). These currencies have recorded some of the largest appreciations against the US dollar since March. The trend appreciation of the Canadian dollar was halted after the BoC expressed concern regarding the impact that persistent strength in the currency may have on the domestic economy. The appreciation of the Brazilian real was partly reversed in October when the Ministry of Finance announced capital controls in the form of taxes on inflows of portfolio capital aimed at alleviating the upward pressure on the exchange rate.
The Chinese renminbi has remained essentially unchanged against the US dollar, whereas some other currencies in the region have appreciated significantly since March this year. As a result, the renminbi has depreciated considerably on a trade-weighted basis (Graph 32).
The Australian dollar has appreciated further against all major currencies in recent months, continuing the trend from around March 2009 (Graph 33, Table 5). The Australian dollar is now close to its July 2008 peak and is around 20 per cent above its post-float average in trade-weighted terms. It is significantly above average against the US dollar, Chinese renminbi and pound sterling, but remains below average against the euro and the Japanese yen. Rising commodity prices and improving investor sentiment have continued to underpin the appreciation in recent months. From March to September, almost all of the appreciation occurred during overnight trading, when global rather than domestic factors are likely to be more influential. More recently, the increase in near-term interest rate expectations in Australia relative to those abroad has also underpinned the currency, which appreciated sharply at the time of domestic data announcements on several occasions.
Volatility in the exchange rate of the Australian dollar against the US dollar remains above its long-run average, but well below levels seen in late 2008 (Graph 34).