Statement on Monetary Policy – May 2009 International and Foreign Exchange Markets

Central bank policy actions

A large number of central banks from both developed and emerging economies have eased policy further as the outlook for economic activity has deteriorated and inflationary pressures have abated. In developed economies, policy rates have been reduced where there remained scope to do so (Table 3). With policy rates at their lower bound in a number of countries, unconventional policy measures have been implemented to further ease monetary conditions and address continuing strains in credit markets.

In the United States, where the policy rate has been effectively zero since late 2008, the Federal Open Market Committee announced in March that it would purchase up to US$300 billion of US Treasuries before September. Yields on long-term US Treasuries fell sharply in response to this announcement. The Fed has also extended the size, coverage and duration of many of its liquidity programs. In particular, to address the elevated level of mortgage rates relative to the policy rate, the Fed announced at its March meeting that it would increase its purchases of agency mortgage-backed securities (MBS) by US$750 billion (to US$1.25 trillion) and agency debt by US$100 billion (to US$200 billion). This contributed to a sharp fall in yields on agency securities and a further fall in 30-year mortgage rates, which are now around 4½ per cent (Graph 14).

The Fed has also announced an increase in the potential size of the Term Asset-backed Securities Loan Facility (TALF) to US$1 trillion from US$200 billion (see below), extended the range of assets eligible for TALF funding and lengthened the maturity of certain loans under the facility. The US Treasury will now provide up to US$100 billion (from US$20 billion) in credit protection to absorb the first losses of this facility. Although the TALF began operations in March, market participation has so far been very low.

Demand for other Fed facilities aimed at improving specific markets has either fallen or remained stable in recent months, signalling some improvement in the relevant financial markets. Demand for funds aimed at providing liquidity to domestic depository institutions and primary dealers has continued to fall from the peaks reached late last year. There has also been a gradual unwinding of some of the Fed's facilities aimed at improving conditions in the market for commercial paper. Similarly, demand for US dollars in international markets via the Fed's swap facility with other central banks has continued to fall, indicating a general improvement in US dollar liquidity offshore. Reductions in the use of these facilities have been broadly offset by the increase in outright purchases of US government and agency securities, leaving the size of the Fed's balance sheet relatively unchanged since late last year, but with some significant changes in its composition.

The European Central Bank (ECB) has lowered its policy rate by a cumulative 300 basis points since its easing phase began in October 2008, to 1¼ per cent. Over the same period the effective overnight rate in the euro area has fallen by around 375 basis points. In March, the ECB announced that it would continue to provide as much domestic liquidity as demanded through fixed-rate auctions, until at least the end of 2009. It also announced that it will decide on additional unconventional monetary policy measures at its meeting on 7 May. Market participants currently expect a further 25 basis point easing in policy rates at that meeting (Graph 15).

The Bank of Japan (BoJ) has expanded its unconventional policy measures in a bid to stabilise domestic banks and financial markets. It has increased its outright purchases of Japanese government bonds and commercial paper, begun outright purchases of corporate bonds, increased the duration and frequency of a number of its corporate financing programs, and extended eligible collateral in its market operations. In addition, the BoJ has outlined terms of the subordinated loans that it will make to domestic banks aimed at supporting banks' capital bases.

In the United Kingdom, the Bank of England (BoE) has lowered its policy rate by a total of 525 basis points since its easing phase began in December 2007, to a lower bound of ½ per cent (Graph 16). However, borrowing rates have fallen by considerably less. With its policy rate at its lower bound, the BoE has commenced a program of quantitative easing aimed at reflating the UK economy, by conducting unsterilised purchases of up to £150 billion in government securities (gilts) and sterling-denominated private sector securities under the Asset Purchase Facility. In the near term, the BoE plans to purchase £75 billion of securities, predominantly longer-term gilts, and to date has purchased around £45 billion in gilts, £2½ billion in commercial paper and £½ billion in corporate bonds.

A number of other central banks have also lowered their policy rates to a point where further monetary easing involves the use of unconventional policy measures. The Swiss National Bank (SNB) has lowered its policy rate by a cumulative 250 basis points, to ¼ per cent, while Sveriges Riksbank and the Bank of Canada have lowered their policy rates by a cumulative 425 basis points each, to ½ per cent and ¼ per cent respectively; Sveriges Riksbank has lowered rates by 150 basis points since the time of the last Statement. In all three cases, policy rates are expected to remain at these historically low levels for the foreseeable future. To further ease monetary conditions, the SNB has announced that it will begin purchases of private sector bonds and has significantly increased the scale of repo operations. In addition, it has intervened in the foreign exchange market in order to prevent any further appreciation of the Swiss franc against the euro to help address its concerns about the risk of deflation. While unconventional policy actions have been discussed at Sveriges Riksbank and the Bank of Canada, both central banks have ruled out further stimulus using these measures unless economic and financial conditions deteriorate further.

Central banks in many other economies have also lowered their policy rates as growth prospects have weakened and inflationary pressures have abated. The Reserve Bank of New Zealand (RBNZ) and the Central Bank of Norway have lowered their policy rates by a cumulative 575 and 425 basis points to 2½ per cent and 1½ per cent respectively. Central banks in many emerging markets have also eased monetary conditions by lowering their policy rates (Table 4).

Government financial policy actions

Many governments have continued to extend and modify existing policy initiatives and/or announce new ones to ease conditions in financial markets.

In the United States, the Government has focused on policies designed to ensure that the banking system is well capitalised and that repercussions from problems in other systemically important institutions are minimised. It has also sought to lower the high level of spreads in credit markets and ease credit conditions for consumers and small businesses.

To ensure that the banking system is adequately capitalised, the balance sheets of major financial institutions in the United States have undergone stress tests to establish their ability to continue lending and absorb further losses in adverse conditions. The results of these tests will be announced on 7 May.

In early March, American International Group reported a fourth quarter loss of US$62 billion – the largest quarterly loss in US corporate history. In response, US authorities announced a restructuring of their support for the company that includes the US Treasury exchanging its existing preferred shares for shares that more closely resemble common equity and restructuring of an earlier loan from the Federal Reserve. The US Treasury also stands ready to provide additional equity capital, of up to US$30 billion in preferred stock, if needed. In late March, Fannie Mae and Freddie Mac received further capital injections of senior preferred stock from the US Treasury of US$15 billion and US$31 billion, respectively, as part of the terms of their conservatorship.

In March, the US Treasury announced details of its Public-Private Investment Program, which is designed to alleviate pressures in the financial system by removing ‘legacy’ loans and securities from the balance sheets of financial institutions. This program will establish investment funds that combine public and private equity capital with leverage provided by the US Treasury, Federal Deposit Insurance Corporation (FDIC) guaranteed debt and Fed loans through the TALF. The leverage may be up to six times for legacy loans. The private sector involvement is intended to assist with the price discovery of these assets. The US Treasury will inject public equity capital on a one-to-one basis with the equity contribution of private investors, using between US$75 billion and US$100 billion from the funds available under the Troubled Asset Relief Program.

The US authorities have also announced several programs designed to ease credit conditions for households and small businesses. In particular, US$75 billion was committed towards preventing mortgage foreclosures by assisting lenders to reduce the debt servicing burdens of ‘responsible’ borrowers, and providing various other incentives to ensure that repayments continue to be made. In addition, loan-to-valuation constraints on refinancing loans owned or guaranteed by Freddie Mac and Fannie Mae will be eased for certain home owners. The Consumer and Business Lending Initiative, a joint program between the US Treasury and the Fed, will expand the TALF from US$200 billion to US$1 trillion for lending against securitisations of consumer, student and small business loans. This also includes the direct purchase of US$15 billion of securities backed by Small Business Administration loans.

In the United Kingdom, the Royal Bank of Scotland (RBS) and Lloyds announced that they would participate in the UK Treasury's Asset Protection Scheme. Each institution will pay a fee in the form of convertible preferred shares to protect around £300 billion and £250 billion of assets, respectively. If all convertible preferred shares held by the UK Government are converted, it stands to own over 80 per cent of RBS and between 50 per cent and 80 per cent of Lloyds, depending on private take-up of Lloyds' announced rights issue.

Elsewhere in Europe, a number of governments have provided further support for their banking systems, primarily through capital injections. In April, Ireland announced plans to buy property-related loans from banks by issuing government bonds directly to the banks. The assets, which comprise performing as well as non-performing loans, have an estimated combined book value of up to €90 billion, possibly representing around 10 per cent of total banking sector assets. The German Government reportedly also intends to implement a plan to remove impaired assets from banks' balance sheets in a bid to improve confidence in the sector and stimulate lending.

In late March, the International Monetary Fund (IMF) introduced significant changes to its lending framework. Among other reforms, it introduced the Flexible Credit Line that provides a line of credit for countries that, despite strong economic fundamentals and a track record of sound policies, are facing increasing strains as a result of the global crisis. Since its introduction, Colombia, Mexico and Poland have all sought access to this facility on a precautionary basis. In general, financial markets have reacted positively to these announcements.

In early April, the Group of Twenty (G-20) governments supported a proposal to provide additional resources to the IMF and multilateral development banks to support growth in emerging and developing economies. In addition, the G-20 supported a general allocation of US$250 billion in Special Drawing Rights – reserve assets that allow countries to obtain freely usable currencies from other members – to increase global liquidity. Under this proposal, US$100 billion would be allocated to emerging and developing economies. In early April, the World Bank Group announced the launch of the Global Trade Liquidity Pool, which will extend credit to banks to support trade in developing markets and address the decline in trade finance. It aims to provide up to US$50 billion of trade liquidity support over the next three years.

Government-guaranteed bond issuance

Issuance of government-guaranteed bonds by financial institutions remained strong in the March quarter, with financial institutions in a number of additional countries starting to issue guaranteed bonds, but moderated somewhat in April. Notwithstanding the guarantees, yields remain substantially higher than sovereign yields, although spreads have generally narrowed (Graph 17).

In the United States, total issuance under the FDIC's Temporary Liquidity Guarantee Program (TLGP) currently stands at US$259 billion (Table 5), and yields on most US dollar-denominated bonds are between 30 to 50 basis points above yields on US Treasuries of equivalent maturity. In March, the FDIC extended the issuance period that will be covered by the TLGP but, in an effort to gradually phase out the program, increased the fee for issuing guaranteed debt.

In the euro area, total government-guaranteed issuance under various programs currently stands at US$242 billion. Yields on most euro-denominated debt are currently between 50 and 140 basis points higher than yields on equivalent German government bonds, with yields on debt backed by lower-rated sovereigns such as Spain and Portugal at the higher end of that range. Yields on bonds guaranteed by the Irish Government are considerably higher than this, given concerns over Irish public finances. Issuance under the UK Government's Credit Guarantee Scheme currently stands at US$121 billion, with the majority of sterling issues trading at yields of between 60 and 120 basis points above yields on equivalent gilts.

Sovereign debt markets

Longer-term sovereign bond yields in most major economies have risen since the beginning of the year, despite some large falls on particular occasions (Graph 18). In the United States and the United Kingdom, yields on 10-year government bonds fell particularly sharply following announcements that the Fed and the BoE would be making unsterilised purchases of longer-dated government bonds: yields on 10-year US government bonds fell by 50 basis points immediately following the Fed's announcement, while yields on 10-year gilts fell by a total of 60 basis points following the BoE's announcement. In the United Kingdom, yields retraced some of this fall following the release of the government budget, which included the announcement of a larger-than-expected bond issuance program. Earlier concerns over the expansion of the US budget deficit had also resulted in some increase in US Treasury yields. Despite this, yields remain historically low, with US 10-year government yields around 3¼ per cent and UK 10-year government yields around 3½ per cent. Yields on German long-term bonds have followed a similar, albeit more muted, pattern to those in the United States and United Kingdom, while yields on Japanese government bonds have risen as a result of a rally in domestic equities and the announcement of another stimulus package by the Government.

In all these countries, yields on short-term government bonds have remained at particularly low levels given expectations that policy rates will remain low for the foreseeable future.

In the first quarter of 2009, spreads between yields on sovereign debt issued by a number of European Monetary Union (EMU) member countries, including Ireland, Portugal and Greece, and yields on German government debt widened markedly (Graph 19). This reflected concerns over the impact of deteriorating economic outlooks and government support measures on budget balances in these countries. Similar concerns led to Ireland's sovereign debt rating being downgraded by Standard & Poor's and Fitch. In general, these spreads have narrowed since mid March.

In emerging Europe, sovereign spreads increased in February on concerns over vulnerabilities in the region stemming from rapid growth of foreign currency-denominated borrowing (Graph 20). Spreads for countries in Western Europe with banking sectors exposed to the region also widened. Subsequently, a number of countries including Estonia, Hungary, Latvia and Lithuania were downgraded by rating agencies. More recently, these spreads have fallen as risk appetite has improved. In emerging Asia and Latin America, spreads on US dollar-denominated sovereign debt to equivalent US Treasuries have continued to narrow from their peaks in October 2008.

Credit markets

Conditions in credit markets have improved noticeably over the course of 2009. This is reflected in a considerable reduction in spreads across many credit markets and a pick-up in issuance in some markets. In money markets, spreads between LIBOR and the expected cash rate narrowed further in the major currencies (Graph 21).

Longer-term US corporate bond spreads have also narrowed and issuance of non-financial corporate debt has increased across all investment-grade rating categories in both the United States and Europe, with sizeable issuance in the March quarter (Graph 22). Notwithstanding this, there has been a sharp rise in the global corporate speculative-grade default rate (Graph 23).

Agency funding spreads to US Treasuries have narrowed since the Fed's announcement in mid March that it would significantly increase the size of its purchases of agency debt and MBS, and are around or below the bottom of the range seen since the Fed began purchases of agency-issued securities in December 2008. Agency issuance of MBS has picked up noticeably in 2009, although there has been almost no issuance of private MBS since July 2008.

Credit default swap (CDS) premia have been volatile over recent months, particularly for financials, reflecting significant changes in market sentiment. However trading in CDS markets remains thin, making these data hard to interpret. Trading conditions are particularly thin for sovereign CDS, partly because the risk on the CDS counterparty is typically greater than on the sovereign itself. In particular, CDS protection buyers will not purchase CDS on a sovereign from a seller who is domiciled in that country. In the case of the Australian market, anecdotal evidence suggests that the daily number of trades is in single digits.

The gross notional amount of outstanding CDS declined by 29 per cent in the second half of 2008 to $US39 trillion according to the International Swaps and Derivatives Association (ISDA). The decline is largely a result of voluntary multilateral terminations, or ‘tear-ups’, whereby CDS holders cancel offsetting trades without affecting their credit risk profiles. This decreases operational costs and capital charges, partly addressing regulators' concerns about the systemic risks in this market. ISDA has indicated that activity in CDS contracts has started to pick up again in the first quarter of 2009.

There have also been significant changes to the contract standards and trading conventions for CDS in an effort to enhance transparency and liquidity in the market. The ISDA's standardised CDS contract requires an auction to determine the value of underlying securities as part of the settlement process in the event of borrower default. In a bid to increase efficiency, North American standardised CDS contracts will require an upfront payment by the protection buyer, will have a fixed coupon of either 100 or 500 basis points, and will not treat restructuring as a credit event. The US Treasury and the Fed are actively supporting moves to settle these standardised contracts through a central clearing house, which it is hoped will address systemic risks in the financial system. In the European CDS market, the terms of standardisation and central counterparties for clearing are still under discussion, with details likely to be outlined in May.


Equity indices for the major markets posted new lows in early March: the Nikkei index fell to its lowest level since 1982; the S&P 500 to its lowest level since 1996; and the Euro STOXX to levels last seen in early 2003 and in 1997. This occurred after a number of financials announced the issuance of additional common stock, in some cases through governments exchanging preferred stock for ordinary stock, and several reported worse-than-expected earnings for 2008.

Since mid March, however, there has been a significant rebound (Table 6). This was the result of an improvement in investor sentiment following reports of increased profitability at a number of financial institutions for early 2009 and further actions by policy-makers to address the deterioration in the global outlook. As a result, equity markets are now at higher levels than those that prevailed at the time of the last Statement.

Daily movements in equity markets have been largely dictated by developments in the financial sector but in general have been less sharp than in late 2008 and early 2009. Nonetheless, volatility remains well above its long-run average.

In contrast to US financials, whose reported quarterly earnings have been mostly negative since the fourth quarter of 2007, earnings of US non-financials only turned negative in the fourth quarter of 2008 and appear to have turned around in the March quarter, with two-thirds of companies reporting earnings above expectations and the rest worse than expected.

Equities in emerging markets have risen markedly since March and have largely outperformed equities in major economies (Graph 24). Equities in these economies have been broadly supported by fiscal stimulus plans, at home and abroad, and by the G-20 commitment to increasing the resources available to the IMF and multilateral development banks. Increases in equity indices in Latin America and emerging Europe have been supported by commodity-related stocks, as the improvement in risk appetite has increased commodity prices. In emerging Europe, the financial sector posted large gains in March after the SNB announced it will act to prevent an appreciation of the Swiss franc, which eased concerns about the prospects for banks in the region with a large proportion of their loans denominated in Swiss francs.

Foreign exchange

The US dollar has depreciated against most other major currencies in the period since the last Statement (Table 7). Flows continued to support the US dollar until early March, after which the improvement in global market sentiment and risk appetite led to a broad-based depreciation of the dollar. The unconventional monetary policy initiatives of the Federal Reserve also weighed on the US dollar, which recorded its largest weekly fall on a trade-weighted basis since 1985 following the Fed's announcement in March of its intention to purchase US Treasuries and increase its purchases of agency debt and MBS. However, the US dollar is still 16 per cent above its multi-decade low reached last year.

The euro appreciated sharply against both the US dollar and the British pound following the announcements by the Fed and the BoE that quantitative easing policies would be implemented (Graph 25). The euro also appreciated against the Swiss franc after the SNB intervened to prevent further appreciation of the currency. However, the euro depreciated in April, amid expectations the ECB will implement unconventional monetary policy measures in May, partially retracing its appreciation against the US dollar, the Swiss franc and the pound.

The Japanese yen has depreciated markedly against the US dollar and the euro since the last Statement. While the BoJ also adopted unconventional monetary policy measures during March, the depreciation of the yen, which began in February, appears to be due to increased risk appetite and the poor domestic economic outlook.

Emerging market currencies have had a mixed performance against the US dollar since the last Statement. Downward pressure continued in February. However, increased risk appetite provided support from early March, with the commitment by the G-20 to increase the IMF's resources also supporting emerging market currencies. The positive effect of improved risk appetite on commodity prices led to particularly marked appreciations for the currencies of commodity-producing economies such as the Brazilian real and the South African rand. The Mexican and Colombian pesos and the Polish zloty appreciated in response to announcements that these countries were seeking a credit line under the IMF's recently-announced Flexible Credit Line (Graph 26). The Bank of Mexico's provision of US dollar liquidity through its swap line with the Fed further supported the peso, which remains well above its record low reached in March notwithstanding swine flu concerns temporarily weighing on the currency in late April. In Asia, both the South Korean won and Indonesian rupiah have appreciated significantly since their recent low points in March 2009 and November 2008, respectively.

Australian dollar

There has been a broad-based appreciation of the Australian dollar over the past few months: on a trade-weighted basis the dollar has appreciated by 13 per cent since the last Statement (Table 8). In part, this reflects the depreciation of a number of major currencies, including the US dollar and British pound, following the announcements that central banks in these countries would be implementing quantitative easing policies. The appreciation also reflects the general improvement in investor sentiment and the pick-up in commodity prices. The Australian dollar is now trading around its long-run average both against the US dollar and on a trade-weighted basis (Graph 27).

Improved risk appetite has reportedly seen some investors return to carry trade strategies, which is corroborated by data showing that speculative traders are holding significant net long positions in the Australian dollar for the first time since October 2008: with interest rates near zero in many developed economies, the interest rates on offer in Australia remain relatively attractive.

Volatility in the exchange rate, as measured by the intraday range, has continued to decline since the last Statement, but remains above its long-term average. Liquidity in the AUD/USD market has improved since the end of 2008 and large intraday movements over recent months have generally been related to significant policy announcements in other countries rather than thin market conditions.