Statement on Monetary Policy – August 2006 International and Foreign Exchange Markets

International financial markets

The relatively calm conditions which characterised global financial markets over the past few years have been punctuated by several bouts of volatility in recent months. The volatility was initially triggered by growing concerns about inflation and the prospect of further increases in policy interest rates in the major economies. This contributed to a further unwinding of the carry trades discussed in the previous Statement. Together with a general reappraisal of the appetite for risk, this resulted in declines in more risky assets including a number of commodities, emerging equity markets and exchange rates in emerging markets such as Turkey, Indonesia and South Africa. The price declines were generally most pronounced in those markets which had previously experienced the largest rises and, in most cases, prices only fell back to the levels prevailing earlier in the year. More recently, the conflict in the Middle East, rising oil prices and the political tensions surrounding North Korea have contributed to further volatility in financial markets.

Official interest rates

The three major central banks are now all in the process of unwinding the sizeable monetary stimulus that has been in place in recent years, although they are at different stages of this process (Graph 8).

The Bank of Japan (BoJ) increased official rates for the first time since 2000, raising the overnight rate by 25 basis points from zero per cent at its July meeting. The impact of this on global financial markets had mainly been felt several months earlier when it became clear that the BoJ was close to the start of its tightening cycle. This had been a major cause of the reduction in yen carry trades in May. Having been widely anticipated, the announcement itself had little impact on financial markets. The market currently expects the BoJ will raise the policy rate by a further 25 basis points towards the end of this year (Table 2). The European Central Bank is more advanced in the process, having begun to increase rates in late 2005, and tightening further at its March and June meetings. With the economic recovery in Europe continuing and with inflation still above 2 per cent, the market currently expects further rate increases later this year.

The US Federal Reserve is most advanced in the tightening process. In late June it raised the federal funds rate by 25 basis points for the 17th consecutive meeting since June 2004. In total, US rates have risen by 425 basis points to 5¼ per cent. The Fed has indicated that further rate rises are dependent on the evolution of the economic outlook and that its central scenario is for growth to stabilise around potential and the inflation outlook to remain benign, albeit with upside risks. Consequently, the market has significantly increased its assessment of the probability that the Fed will pause at its next meeting. The Bank of Canada paused in its tightening process in July after having tightened at each meeting since mid 2005. The market currently expects that rates will remain unchanged at 4¼ per cent for the rest of the year.

Policy rates continue to be raised from low levels in Switzerland, Sweden and Norway, with the central banks increasing policy rates by 25 basis points since the last Statement, to 1½ per cent, 2¼ per cent, and 2¾ per cent respectively. The market is currently expecting the Bank of England to increase rates by 25 basis points later this year.

Given the very strong growth outcomes in China, the monetary authorities have taken further steps to tighten policy settings. In an attempt to dampen rapid credit growth of 15 per cent per annum the interest rate banks charge on loans was raised in May, and the amount banks are required to hold in reserves was increased twice in recent weeks. Additional administrative measures were also introduced to contain activity in the housing sector. The success of policy measures to date has been limited as monetary growth of 18½ per cent continues to outpace the official target of 16 per cent for this year, in part due to the difficulties in sterilising intervention in the foreign exchange market.

Elsewhere in Asia, policy rates continued to be raised with central banks in Korea, India, Thailand and Taiwan all increasing rates since the last Statement. The level of rates still remains relatively low in real terms. In some countries, large depreciations in their exchange rates have contributed to central banks, including those in South Africa, Turkey and Iceland, raising policy rates significantly. In contrast, Indonesia and Brazil have lowered rates as inflation pressures in those countries have eased.

Bond yields

Government bond yields have risen noticeably in the major markets over the past year to be the highest they have been for several years (Graph 9). Strong global economic activity, heightened concerns about inflation and expectations of further interest rate tightening by the major central banks have been the major factors pushing up yields. Yields have come off their highs in recent weeks as market participants moved out of riskier assets into government bonds in the wake of recent political instability.

Yields on US 10-year government bonds are currently trading at around 5 per cent, having reached their highest level in this cycle of 5¼ per cent in late June. Similarly in Germany, 10-year government bond yields are back trading around 4 per cent, having risen to 4¼ per cent in recent months. In Japan, long-term yields are just under 2 per cent. The increase in yields at shorter maturities was particularly marked due to the prospect of an increase in interest rates by the Bank of Japan (Graph 10).

Spreads on emerging-market and corporate debt rose during the period as a number of global events caused market participants to move away from more risky assets. The increase in spreads was largest for US corporate and emerging European debt. However, despite the rise, spreads remain at low levels by the standards of the past decade.

Equity markets

After having risen quite strongly during the first part of the year, global equity markets have experienced pronounced volatility since the last Statement as investors appeared to have reappraised their appetite for risk (Graph 11, Table 3). Losses have tended to be most severe in emerging markets where the preceding gains were strongest. In particular, equity prices fell substantially in a number of Latin American and emerging European countries, although these declines unwound only part of the gains in these markets earlier in the year. While equity markets staged a brief recovery in late June, heightened political instability since then has led to renewed volatility. The Israeli-Lebanese conflict, bombings in India, and concern over North Korea's missile testing all contributed to the move away from risky assets.

Exchange rates

The US dollar appreciated against several currencies over the past three months but remained little changed on a trade-weighted basis (Table 4). The dollar appreciated against the yen, despite the decision by the Bank of Japan to raise its official interest rate (Graph 12). This possibly reflected a judgment by market participants that Japanese interest rates would continue to be well below US rates for a long time.

The Chinese renminbi has continued to appreciate against the US dollar, although in recent months the pace of appreciation has been slow. Since the initial revaluation in July 2005, the renminbi has only appreciated by a further 1½ per cent against the US dollar. A number of other emerging-market currencies have experienced noticeable depreciations since the last Statement due to volatility in commodity prices, the unwinding of carry trades, equity market weakness and general paring back of speculative positioning. The declines were most evident in the Turkish lira, Indonesian rupiah, Brazilian real and South African rand. These currencies now appear to have stabilised, with the Brazilian real and Indonesian rupiah still stronger against the US dollar than at the beginning of the year.

Australian dollar

The Australian dollar is little changed in net terms since the last Statement, both against the US dollar and on a trade-weighted basis (Graph 13, Table 5). Over the period it has moved in a range between US73 and US77 cents. It peaked in the first half of May, subsequently depreciated through to the end of June as commodity prices experienced a sharp correction, before rising again recently. Currently the exchange rate is trading at a little over US76 cents, and 64 against the trade-weighted index. These levels are similar to the average of the past couple of years. The relative stability of the currency over the past few years is the result of two opposing forces. The continuing strong rise in the terms of trade has been supportive of the currency but the narrowing of the interest differential with the US has had the opposite effect.

The impact of narrowing interest differentials can be seen in the declining level of Australian dollar Eurobond issuance after the surge in 2003 and 2004. Recent levels of issuance have fallen short of maturities (Graph 14). Redemptions scheduled over the remainder of the year are also relatively large compared to issuance levels in 2006 to date.

One gauge of investor sentiment towards the Australian dollar is the net speculative positioning in Australian dollar futures on the Chicago Mercantile Exchange. These positions have generally been net long recently, though somewhat smaller than was the case in 2005 (Graph 15).

With the exchange rate at levels only a little above average, the Bank has not been adding to net reserve holdings since the last Statement. Its market purchases of foreign exchange have been only sufficient to cover sales to the Government. After taking acccount of earnings, net reserves are a little higher since May, at just over A$30 billion. The Bank's holdings of foreign exchange under swap agreements, which are largely determined by liquidity management operations, have increased to A$40 billion.