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

Overseas markets

Official interest rates

For some time, the major central banks around the world have engaged in a process of normalising interest rates after the very low levels reached in 2003 (Graph 11). The exception to this had been the Bank of Japan (BoJ) which until recently had been combating deflation. With the Japanese economy continuing to improve and prices starting to rise, however, the BoJ too has now started the process of normalising policy. The BoJ has begun to withdraw the vast amounts of excess liquidity it had provided banks under its policy of ‘quantitative easing’. This has not yet resulted in any rise in official interest rates, which remain at zero. The reduction in the provision of liquidity to more normal levels consistent with required reserve holdings is expected to take a number of months (Graph 12). While largely technical in nature, many observers expect it to be followed soon after by a rise in policy rates.

The US Federal Reserve, which started tightening in mid 2004 and has since raised rates to 4¾ per cent, has recently indicated that the process of normalisation may be nearing an end. Markets expect the Fed to increase its policy rate by a further 25 basis points, to 5 per cent, at its next meeting in early May (Table 3).

The European Central Bank (ECB) is less advanced in this process, having only begun to increase rates late last year. Following the two 25 basis point increases over the past six months, current market expectations are for two further increases of 25 basis points over the next six months, which would lift rates to 3 per cent. Elsewhere in Europe, policy rates also continue to be normalised in Norway, Denmark, Sweden and Switzerland.

The Bank of Canada continued on the gradual tightening path which it commenced in 2004, raising rates twice since the last Statement, from 3½ to 4 per cent. Markets expect some further tightening over the next six months. In contrast, the markets expect the Bank of England and the Reserve Bank of New Zealand to leave rates unchanged at 4½ and 7¼ per cent respectively over the next six months.

In non-Japan Asia, policy rates also continue to be raised from historically low levels, with the central banks of China, Korea, Malaysia, Thailand and Taiwan each increasing rates since the last Statement. Nonetheless, real interest rates in Asia remain unusually low. In other emerging markets robust economic growth and concerns about inflation saw central banks in Chile and Israel increasing rates. However, rates were lowered in Brazil, Mexico, Poland and Turkey as inflationary pressures continued to ease.

Bond yields

After a prolonged period of below-average volatility, government bond yields have risen in all the major markets and are now noticeably above the ranges in which they had traded in 2005 (Graph 13). The main catalyst for this reassessment appears to be ongoing strength in the global economy and the prospect of simultaneous policy tightening in the major economies, with much of the increase being in real yields rather than in inflation expectations.

Yields on US 10-year government bonds, which had been in the range of 4 to 4½ per cent for much of the past 2 years, are currently trading above 5 per cent – the highest level since 2002. However, the yield curve has remained essentially flat over recent months, with long-term bond yields rising broadly in line with the increase in policy interest rates. In Japan, long-term yields have been on an upward trend since the middle of last year, with the 10-year yield rising from around 1¼ per cent to be currently trading around 2 per cent – the highest since 1999 (Graph 14). The monetary policy announcement in March saw only a relatively modest increase in long yields but yields at shorter maturities rose more rapidly. In Germany long yields are now trading around 4 per cent, having been almost 3 per cent late last year.

As yet, the increases in policy interest rates and government bond yields have not had any effect on spreads on emerging-market and corporate debt, which remain at low levels by the standards of the past decade (Graph 15).

Equity markets

Global equity markets have continued to post steady gains since the last Statement, with the positive economic outlook being partially countered by the rise in global interest rates and oil prices (Table 4).

In the US, the S&P 500 has risen by 4 per cent since the last Statement, although it remains 14 per cent below its 2000 peak. Japanese equities have been particularly volatile over recent months, but on average have increased by similar amounts to US share prices since the last Statement. In April, the TOPIX reached a 15-year high, but remains 40 per cent below the 1989 peak. Equity markets reacted favourably to the BoJ's announcement that it was ending quantitative easing, interpreting it as validation of recent positive economic developments. European equity markets have performed particularly well since the trough of 2003, and this trend has continued throughout 2006.

The emerging markets of Asia and Latin America have on average recorded strong share price gains recently, in the order of 10 per cent each (Graph 16). Regulatory changes saw China's foreign-currency-denominated B shares, which are available to both foreign and domestic investors, rise strongly. Indonesian share prices also rose faster than average as the policy measures taken by the Indonesian Government after the sharp fall in the exchange rate last year have restored market confidence.

Exchange rates

The policy interest rate changes announced by major central banks in recent months have not had much impact on exchange rates between the major currencies. However, recently the US dollar has depreciated against the major currencies to be at the bottom of the range it has traded over the past year or so (Graph 17, Table 5).

The impact of recent monetary policy changes in the major economies has been felt mainly by a number of other currencies. Two of the biggest changes have been in the New Zealand dollar and the Icelandic krona. The background to this is that over the past 2–3 years, very low short-term interest rates in a number of countries such as Japan and Switzerland had seen investors borrow money in these countries to buy assets in countries where interest rates were higher. A disproportionate amount of this money had gone to New Zealand and Iceland, due to their particularly high interest rates.

This so-called ‘carry trade’ sought to benefit from the interest rate differential between the two currencies, though it faced the risk of foreign exchange losses if the currency in which the funds were borrowed were to appreciate. As such, the Japanese monetary announcement triggered a sharp reversal of these flows because investors feared that the yen might appreciate, resulting in currency losses which could easily more than offset the return from the interest differential. While a range of currencies, including the Australian dollar (see below), were affected by this, the most heavily affected were the New Zealand dollar and Icelandic krona. Both had appreciated sharply previously, and the subsequent exodus of capital saw these currencies fall by about 15 per cent in a matter of a few weeks (Graph 18). In the case of the New Zealand dollar at least, this simply restored a more normal level to the currency and has generally been seen as a welcome development by the authorities.

Asian exchange rates generally have risen modestly against the US dollar recently, continuing a trend that has been evident since late 2005 (Graph 19). This reflects favourable economic conditions in Asia and reduced intervention by the authorities to slow the pace of appreciation (with the exception of China).

The pace of appreciation of the Chinese exchange rate picked up on average in the past three months, with the renminbi rising by half a per cent against the US dollar over the period, although in recent weeks the currency has depreciated slightly. The cumulative appreciation since the July 2005 revaluation now amounts to 1¼ per cent. Foreign exchange intervention by the authorities has remained heavy, with US$21 billion added to reserves in March, bringing the cumulative increase in 2006 to date to US$56 billion. As a result China's official reserves now surpass Japan's. Pricing in the non-deliverable forward market suggests that markets expect the renminbi to be around 4 per cent higher in twelve months' time, which is in line with the average expectation since last year's revaluation.

Latin American currencies have also generally appreciated modestly against the US dollar since the last Statement, supported by generally favourable economic conditions in the region and ongoing strength in commodity prices. The main exception had been the Mexican peso, which has depreciated by around 5 per cent in part reflecting a declining interest differential with the US.

Australian dollar

Since the last Statement the Australian dollar has experienced two broad movements: a relatively sharp decline in late March, followed by a similarly sharp rise in April (Graph 20). The move lower in March was part of the global unwinding of carry trades (see above) and saw the Australian dollar fall to its lowest levels since September 2004, both in trade-weighted terms and against the US dollar. While sizeable, the move was much smaller than that experienced by the New Zealand dollar at that time, resulting in a sizeable appreciation against the latter currency (Graph 21). The subsequent appreciation in April was underpinned by a sequence of stronger-than-expected domestic economic data releases and resurgence in global commodity markets, with the appreciation particularly marked against the US dollar given that currency's recent decline.

Speculative positions in Australian dollar futures on the Chicago Mercantile Exchange provide an indication of investor sentiment towards the Australian dollar. The net long positions that had been held through most of 2005 and early 2006 were unwound over February and March, with positioning moving to record net short levels in late March (Graph 22). However, sentiment swung back in April, with small net long positions held by speculators. The relatively large movements in the Australian dollar over March and April caused volatility measures of the currency to rise to their highest level in over a year (Graph 23).

Australian dollar Eurobond issuance has remained at relatively modest levels in recent months. With increased levels of redemptions, net issuance has become negative, which may have weighed on the Australian dollar recently. Redemptions scheduled for coming months also generally exceed recent issuance levels.

With foreign exchange reserves at a relatively comfortable level and the Australian dollar only a little above its longer-run averages, over recent months the Bank only purchased sufficient foreign exchange to cover sales to the Government. Net reserves therefore have not changed much apart from valuation effects, and currently stand at $29¼ billion. The Bank's holdings of foreign exchange under swap agreements have increased over recent months to $35 billion, as the Bank has made substantial use of these instruments to help manage domestic liquidity conditions.