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

International financial markets

Official interest rates

The three major central banks remain at quite different stages of their monetary cycle (Graph 10). In the US, the first phase of the cycle appears to be complete, with the Fed having left its policy rate unchanged for the past three meetings. This follows 17 consecutive increases of 25 basis points, which lifted the rate from 1 per cent in July 2004 to 5¼ per cent currently, a level which is broadly in line with long-run averages. In its recent statements, the Fed has indicated that upside risks to inflation remain but financial markets are currently pricing in some probability of an easing in policy in the first quarter of 2007 (Table 1).

The European Central Bank's (ECB) tightening phase has continued, increasing the policy rate by 25 basis points at both its August and October meetings, to bring the rate to 3¼ per cent. Economic growth in the euro area has strengthened, and the ECB continues to see some upside risks to the inflation outlook. Currently, the market anticipates the ECB will raise rates by a further 50 basis points in the next six months.

The Bank of Japan (BoJ) only commenced its tightening cycle in July this year when it raised official interest rates to 0.25 per cent; it has since kept its policy rate unchanged. Market expectations of the timing of the next increase were pushed back in August after revisions to consumer price data revealed that inflation was lower than previously thought. Markets expect the next tightening by the BoJ to be early next year.

The Bank of England surprised markets by raising rates by 25 basis points in August, and further tightening is expected in the coming months. Monetary policy was also tightened in Sweden, Switzerland and Norway. Rates in these countries, particularly Switzerland, were previously at unusually low levels. In contrast, policy has not been changed in Canada and New Zealand over the past quarter, though some further tightening is expected in the latter in the coming months.

Monetary conditions have been tightened in China to curtail the growth in money and credit, which is being boosted by the People's Bank of China's foreign exchange intervention. The benchmark lending and deposit rates were raised in August while the required reserves ratio for banks was increased in November. The lending rate was previously raised in April, while the required reserves ratio on banks had already been increased twice this year. These measures have had some success; monetary growth slowed in August and September to just above the official target of 16 per cent.

In other emerging markets, there have been divergent trends in monetary policy reflecting differences in the outlook for inflation and growth. Monetary policy was tightened on inflation concerns in the Czech Republic, Hungary, India, Korea, Taiwan and South Africa. In contrast, Bank Indonesia continued to ease policy, bringing the cumulative easing since May to 250 basis points reflecting its assessment that inflation pressures in Indonesia are easing. For similar reasons, official interest rates were lowered in Brazil for the 11th time in the current cycle. In Israel, the policy rate was reduced by 25 basis points, having been raised twice earlier in the year, with inflation now projected to fall below target.

Bond yields

Government bond yields in the three major economies (Graph 11) have fallen since the last Statement, mainly due to the market's assessment that the risks of a more pronounced slowdown in the US economy have increased. Yields are well below their peaks earlier in 2006.

US long-term yields are currently around 4.65 per cent, compared with 5 per cent three months ago. With the policy rate at 5¼ per cent, the yield curve is noticeably inverted. While structural factors such as excess global savings may still be depressing long-term interest rates, the negative slope in the yield curve nonetheless implies that markets see some possibility of a Fed easing in the year ahead.

In Germany and Japan, yields have fallen to a lesser extent than US yields, primarily as a result of data suggesting generally favourable economic conditions in both regions, and expectations of further monetary policy tightening. Several rating agencies downgraded Italy's sovereign credit rating in October, reflecting concerns about the fiscal outlook. Despite this, Italian yields remain only around 25 basis points higher than in Germany.

Spreads on high-yielding corporate debt and emerging-market debt narrowed since the last Statement, when markets were still being affected by the risk-reduction trades over May and June (Graph 12). Emerging-market debt spreads are at historically low levels. The increased risk of a slowdown in the US economy has seen spreads on low-rated corporate debt in the US rise somewhat, as such an outcome could damage corporate finances. However, to date default rates remain low.

Equity markets

Global equity markets have posted steady gains since the last Statement, boosted by lower oil prices, and a pause in US policy rates (Table 2). The declines in the oil price had differing impacts on global equity markets, with markets where the energy sector has a relatively high weight, such as in Canada and Russia, tending to underperform. Nevertheless, most equity markets have recorded solid rises over the year to date. One exception has been the Japanese market which is little changed from the beginning of the year. Price-earnings ratios remain around their historical averages, with the rise in share prices broadly matched by higher earnings.

The technology-dependent NASDAQ index, which experienced a large decline in the June quarter, has led the strength in US equities since the last Statement. In early October, the blue-chip Dow Jones index broke through its previous peak reached in January 2000.

In line with developments in the major markets, emerging equity markets of Asia and Latin America have continued to recover from the losses sustained mid year (Graph 13). The markets which suffered the largest losses, such as those in Indonesia and India, have been particularly strong, rising by around 20 per cent since the last Statement to more than recoup earlier losses. Asian equity markets, with the exception of South Korea, have improved over 2006, continuing the rally in place since 2003. Chinese equities, which were relatively unaffected by the events mid year have been very strong, rising by more than 60 per cent in 2006 to date.

Exchange rates

Foreign exchange markets have been relatively subdued over recent months, with daily volatility for major currencies now at its lowest level in almost a decade (Graph 14). The US dollar has not changed much against the euro over the past three months, notwithstanding the decision of the US Federal Reserve to leave monetary policy on hold and the further policy tightening in Europe (Graph 15, Table 3). The most notable development in recent months has been the gradual depreciation of the yen. One factor contributing to this may be the restoration of carry trades following an assessment that, despite the end of the zero interest rate policy, rates will remain low in Japan for some time to come. Another factor appears to be a greater appetite for portfolio diversification into foreign assets by Japanese investors. As the Japanese economy continues to recover, they are becoming more confident in taking on the foreign exchange risk that comes from buying offshore assets. Part of this shift to offshore investments has been by Japanese households. In comparison with households in many other countries, they have in the past been very conservative in their investments, holding the bulk of their financial wealth in the form of domestic bank deposits. But the ongoing low return on these investments is encouraging Japanese households to diversify into other assets, including offshore assets. In real effective terms, the yen is at its lowest level since 1985 (Graph 16).

The gradual appreciation of the Chinese renminbi has continued in recent months (Graph 17). Daily volatility in the renminbi has increased over the period, but remains low compared to other major currencies. As part of the gradual program of reform, a foreign exchange swap market has been created and a trial of a full convertibility zone is being conducted in the port of Tianjin. This would allow residents and firms in that region to freely trade in foreign currencies, and qualified institutions to expand their foreign investment activity there.

Most emerging-market currencies have made modest gains against the US dollar over the past three months. These gains have been achieved in a number of countries despite negative political events such as the Thai military coup, Brazilian corruption scandal and civil unrest in Hungary. One notable exception has been the South African rand which has depreciated by around 7 per cent over the period with its trade position adversely affected by the decline in gold prices.

Australian dollar

The Australian dollar has appreciated against the US dollar recently, but remains in the relatively narrow range it has traded in over the past two years (Graph 18, Table 4). The exchange rate has also been relatively stable on a trade-weighted basis, although it has risen to its highest level against the yen in nearly 10 years, reflecting the weakness of the yen on global markets described in the previous section. The overall stability of the currency is demonstrated by the fact that realised volatility in the Australian dollar over recent months has been well below its post-float average (Graph 19). Volatility implied from option prices has also fallen to its lowest level since 1997.

Sentiment towards the Australian dollar remains positive, with A$ eurobond issuance at moderate levels and net speculative positioning in Australian dollar futures on the Chicago Mercantile Exchange rising to a record long position.

With the exchange rate remaining within its recent range, the Reserve Bank has kept its foreign exchange purchases to those sufficient to cover sales to the Government. Net reserves are around $30½ billion. The Bank's holdings of foreign exchange under swap agreements, which are largely determined by liquidity management operations, have fallen by $4 billion, to $35 billion, since the last Statement.