Statement on Monetary Policy – February 2010 International and Foreign Exchange Markets

Credit markets

Credit market conditions improved significantly over 2009, although concerns have emerged in some sovereign debt markets. Credit spreads are now generally well below crisis levels and many borrowing rates, in absolute terms, are around historically low levels. In money markets, spreads between LIBOR and the expected cash rate for most major currencies have been broadly stable since October 2009 (Graph 14). Reduced concerns regarding counterparty credit risk are also evident in falling credit default swap (CDS) premia. After peaking around the start of 2009, CDS premia on both investment-grade and riskier sub-investment-grade corporate debt have fallen, although they remain higher than they were pre-crisis.

In the United States, non-financial corporate bond spreads for both highly and lower-rated (‘junk’) bonds have continued to narrow and are around their lowest levels since the beginning of 2008 (Graph 15). After increasing strongly in the first half of 2009, bond issuance by US non-financials has fallen back to around its pre-crisis average (Graph 16).

Bond issuance by US financial institutions remains subdued reflecting the expiry of the government-guarantee program in October 2009, slower balance sheet growth of financial corporates and a significant amount of issuance in early 2009. Bond issuance by European financial institutions rose strongly in January and is expected to remain high in the period ahead reflecting the fact that European banks have a higher-than-usual amount of debt to refinance in the next couple of years. Some banks in Europe and the United Kingdom have continued to issue under their respective government-guarantee schemes, although global government-guaranteed issuance remains low.

Central bank policy

Policy interest rates in most advanced economies have remained at their lower bounds (Table 2). Consistent with the commitments by a number of these central banks – including the Fed, the Bank of Canada and Sveriges Riksbank – to keep policy rates low for some time, current financial market pricing anticipates that policy rates in most advanced economies will not begin to rise until the second half of this year, at the earliest. In contrast, the Bank of Israel and Norges Bank increased their policy rates further in December. In emerging markets, the People's Bank of China and the Reserve Bank of India increased their required reserves ratios for depository institutions, while central banks in Russia, Turkey and Hungary further reduced their policy interest rates in recent months.

With their policy rates at a lower bound, several central banks in advanced economies have continued to ease monetary policy through outright asset purchases. However, the rate of asset purchases has slowed in recent months as the programs approach their completion.

In the United States, the Fed has continued to purchase agency mortgage-backed securities (MBS) and agency debt, after completing its program to purchase US$300 billion in US Treasury securities in October last year. The Fed still has approximately US$110 billion in purchases of agency securities remaining of an ultimate target of US$1,425 billion, with agency MBS accounting for most of the purchases. Recently, the rate at which these securities have been acquired has slowed to ensure that markets are not adversely affected when these programs come to their scheduled completion by the end of March. Reflecting the impact of these purchases, 30-year fixed mortgage rates are currently only a little above their trough despite the rise in Treasury yields (Graph 17).

The Bank of England (BoE) expanded its target for asset purchases by £25 billion to £200 billion at its November meeting and has recently reached this target on schedule, with the vast majority of purchases having been gilts. The European Central Bank (ECB) has purchased around €35 billion in euro-denominated covered bonds with an additional €25 billion of these securities to be purchased by the end of June this year. While purchases of these securities have provided ongoing support for issuance in the primary market, spreads in the secondary market have remained broadly unchanged in recent months. The Bank of Japan (BoJ) has continued to purchase Japanese government bonds and small amounts of stock in financial institutions. The Swiss National Bank (SNB) decided at its December meeting to cease outright purchases of private-sector bonds (but remains committed to preventing appreciation of the Swiss franc against the euro).

Demand for central bank liquidity facilities has also continued to recede, with ongoing improvements in financial markets prompting some central banks, including the Fed, ECB, BoJ and SNB, to end some of their facilities. Earlier this month, the Fed terminated its US-dollar swap facility with other central banks. At the same time, the Fed closed a number of other domestic liquidity facilities – including the Primary Dealer Credit Facility, the Term Securities Lending Facility and facilities aimed at supporting the functioning of commercial paper markets. In contrast, funds have continued to be sought through the Term Asset-backed Securities Loan Facility, with the facility recently supporting the first new commercial MBS issue since June 2008.

In line with the fall in demand for its liquidity facilities, the ECB has also begun to unwind some of these operations. It conducted its final 12-month refinancing operation in December and announced that it will end six-month refinancing operations in March. The Bank of Canada and Sveriges Riksbank have also taken steps to unwind some of their domestic liquidity facilities as conditions in financial markets have improved. In contrast, the BoJ announced at its unscheduled monetary policy meeting in December that it would temporarily provide ¥10 trillion (US$110 billion) in liquidity at the overnight rate in an attempt to lower longer-term money market rates.

The Fed's balance sheet has expanded modestly in recent months, as the general fall in liquidity-providing facilities has been more than offset by the rise in securities held outright. However, since mid 2007 the Fed's balance sheet has increased by around 150 per cent. Over the same time period, the balance sheets of the BoE and ECB have increased by around 200 per cent and 50 per cent respectively (Graph 18).

In response to the large accumulation of reserves held by depository institutions resulting from the Fed's liquidity operations and outright asset purchases, the Fed has recently announced steps which could be used to reduce the aggregate quantity of excess reserves. At this stage the Fed has conducted a number of reverse repo operations designed to test the readiness of this tool, but they have been small enough to have no material impact on reserves. The Fed has also proposed the introduction of a term deposit facility and has stressed that neither of these developments represents a change in monetary policy stance.

Government financial policy actions

The ongoing normalisation of credit markets has seen government financial policies in major economies maintain a focus on longer-term initiatives designed to support stability and improve regulatory oversight. Governments have, for the most part, continued to wind down emergency measures, and some governments are seeking to recover taxpayer losses associated with financial sector failures.

In the United States, financial reforms in draft legislation include creating a Financial Stability Council that will identify and increase the oversight and regulation of systemically important financial institutions, and establishing procedures for managing failing institutions to prevent the need for future government bailouts. These reforms would leave the Federal Deposit Insurance Corporation (FDIC) with resolution authority over systemically important institutions. Similarly, the European Council is seeking to implement a European Systemic Risk Board that will monitor and report on macro-prudential risks in the banking, insurance and securities markets.

The US draft legislation will also require all standardised over-the-counter (OTC) derivative swap transactions between dealers and major swap participants to be traded on an exchange or electronic platform and cleared by a central counterparty. Separately, major financial market participants agreed in mid January to expand central clearing for interest rate and credit derivatives, to broaden regulatory reporting on OTC derivatives transactions, and to improve risk management for derivatives transactions not cleared centrally.

Most large US financial institutions have redeemed preferred securities issued to the US Treasury under the Troubled Asset Relief Program (TARP) after raising more equity. The US Treasury extended the duration of the US$700 billion TARP to October 2010 and expects that no more than US$550 billion of this will be deployed. The US Treasury stated that it may also expand its commitment to the Fed's Term Asset-backed Securities Loan Facility.

Further losses of around US$20 billion at housing agency Fannie Mae in the third quarter resulted in additional 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$60 billion. In contrast, the housing agency Freddie Mac, although reporting a third-quarter loss of US$5 billion, maintained a positive net worth, leaving its total funding from the US Treasury unchanged at around US$50 billion. The US Treasury has amended the terms of its support to the two housing agencies such that it may now provide unlimited capital injections over the next three years to ensure each agency maintains a positive net worth; previously the limit was US$200 billion per firm. Also, the US Treasury ended its purchases of MBS guaranteed by the agencies in December, after purchasing around US$220 billion of these securities to support the mortgage market.

The US Administration has proposed implementing a fee on the liabilities of large financial institutions for at least 10 years from 30 June in order to recoup losses under the TARP. It has also proposed measures restricting banks from owning, investing or sponsoring hedge funds, private equity funds or proprietary trading operations, while also extending the market-share cap on deposits to other non-deposit funding to limit industry concentration. The FDIC has also proposed to charge higher fees for deposit insurance for banks whose compensation plans encourage excessive risk-taking.

The UK Government announced a temporary 50 per cent levy on bonus payouts over a certain threshold by banks based in the United Kingdom on the basis that banks had avoided much larger losses as a result of the Government's bailout of the banking system. The French Government has announced similar plans.

The Basel Committee on Banking Supervision also proposed changes to improve the quality of banks' capital, strengthen capital requirements and set new standards for liquidity risk management. The changes are expected to be introduced by the end of 2012.

Sovereign debt markets

In the major economies, short-term government bond yields have generally remained within the low trading ranges seen since late 2008 as policy rates are expected to remain low for some time. Yields on short-term Japanese government bonds, however, have fallen to their lowest level in around five years.

Longer-term government bond yields in the United States recently rose toward the upper end of their trading range of the past year, reflecting better economic data, but have since partly retraced some of this increase (Graph 19). Longer-term bond yields in the United Kingdom have also risen, partly reflecting concern about rising domestic inflation. In contrast, longer-term bond yields in Germany have been relatively stable for at least the past six months, as they have in Japan, despite S&P downgrading the outlook for Japan to negative.

In Europe, spreads between sovereign debt issued by European Monetary Union member countries and the German Government have generally widened in recent months. Spreads on countries experiencing negative credit rating news have widened significantly (Graph 20). Notably, Greek government bond spreads have widened by around 210 basis points since early November. The three major credit rating agencies downgraded Greece's credit rating in December and have put a negative outlook on Greek government debt, indicating the possibility of further downgrades over the next two years if the government budget deficit is not reduced. S&P also placed Portugal and Spain on negative outlook citing deteriorating public finances. Iceland's credit rating was downgraded by Moody's and Fitch in response to political, economic and financial uncertainty with respect to its recovery from its severe financial crisis. The spread on Ireland's sovereign debt narrowed after the Government announced significant cuts to public spending in early December 2009.

Spreads of emerging market US dollar-denominated debt have generallly narrowed over the past three months, as emerging economies recover more quickly than the United States and other advanced economies, despite some credit concerns in Dubai, Mexico and Ukraine (Graph 21). In Dubai, some government-related entities sought to delay debt repayments, which raised concerns about a possible default and of contagion to other markets. In response, the credit ratings of a number of government-related entities were downgraded, although Abu Dhabi later provided financial support to Dubai. Fitch and S&P also downgraded Mexico's credit rating due to lower oil revenue, which comprises a large portion of government revenue, and Fitch downgraded Ukraine's sovereign credit rating in November after the IMF suspended funding when the Government introduced policies that are expected to result in a significant widening of Ukraine's budget deficit.

In contrast, Moody's upgraded the outlooks for China, Hong Kong and India to positive from stable, citing strong external positions. In Europe, Russia's outlook was upgraded by S&P and Fitch due to a more favourable economic and fiscal outlook. Turkey's rating was upgraded by Moody's and Fitch, reflecting the resilience of its economy to the financial crisis. Indonesia was upgraded by Fitch for similar reasons.


Major equity price indices continued to trend higher until late January, supported by broadly positive macroeconomic data and the repayment of TARP funds by several US financial institutions (Graph 22). They subsequently fell sharply, prompted by the US Administration's proposed restrictions on banks. Periods of heightened risk aversion on concerns surrounding the sovereign creditworthiness of Greece and Dubai have also weighed on equities at times. However, equity prices have recovered nearly half of the declines from their 2007 peaks.

In the United States, further upward revisions to forecast earnings have generally kept pace with the increase in equity prices, resulting in the forward-looking price-to-earnings (P/E) ratio remaining around its long-run average (Graph 23). However, the ratio remains well above its recent trough in November 2008. Volatility continued to decline to be around its long-run average in mid January before spiking higher as equity prices fell sharply.

Fourth-quarter earnings reports from major US financial institutions continued to identify investment banking operations as the main source of profit (Graph 24). In contrast, retail operations continued to record losses or weak net income, reflecting further large provisions. As a result, banks whose operations are more heavily oriented toward investment banking, such as JPMorgan Chase and Goldman Sachs, have continued to post stronger results than banks focused on retail lending, such as Bank of America and Citigroup. However, some of the weakness in net income in the quarter, for the latter two banks in particular, reflects temporary costs associated with TARP repayments to the US Treasury.

Japanese equities have outperformed other major equity markets in recent months, after declining over most of the second half of 2009 (Table 3). Equity prices have risen by almost 15 per cent since late November – driven by a recovery in the stocks of exporters as the yen depreciated – to retrace their decline in the second half of 2009. Developments surrounding the bankruptcy of Japan Airlines led to considerable volatility in the company's stock price as well as the broader market; Japan Airlines' stock will be delisted on 20 February.

Emerging market equities have largely tracked movements in advanced-economy markets and commodity prices in recent months, with emerging European equities outperforming (Graph 25). An exception is Chinese equities, which have fallen in recent months as the announcement of measures to curb the rapid expansion in credit more than offset the effects of positive domestic economic data. Equity price indices for emerging economies have approximately doubled since their troughs in late 2008 and early 2009, and a number of Latin American equity markets are now back around, or above, their pre-crisis peaks.

Hedge funds

The recovery in equity markets has also been reflected in global hedge funds' returns, which were positive in the December quarter. Hedge funds recorded an average 3 per cent return in the December quarter and a small positive net inflow of investor funds, the first since 2008. Funds under management in the industry are now 20 per cent above the March quarter trough, although they remain considerably below the peak in mid 2008 (Graph 26).

Foreign exchange

Developments in foreign exchange markets have been broadly consistent with changes in general financial market sentiment. Overall, volatility in foreign exchange markets continues to be well below its peak recorded in late 2008 but above its long-run average.

The US dollar depreciated over most of 2009 but has appreciated in recent months in trade- weighted terms (Table 4). Positive US economic data releases, rising US Treasury yields relative to those for some other major economies, and rising risk aversion in late January have underpinned the US dollar. On a trade-weighted basis, the US dollar is currently around 12 per cent below its March 2009 peak (Graph 27).

The euro has depreciated against the US dollar over recent months after appreciating significantly from early 2009 (Graph 28). Concerns over Greece's fiscal position and a pushing-out of market expectations of when the ECB will increase its policy rate contributed to the recent depreciation. The UK pound sterling has also depreciated against the US dollar over recent months, in part reflecting concerns regarding the level of UK government debt. Most commodity-related currencies – including the Australian dollar (see below), Canadian dollar, New Zealand dollar and South African rand – have moved broadly sideways against the US dollar in recent months (Graph 29). In contrast, the Brazilian real has depreciated by 7 per cent over this period. While these currencies remain below their most recent peaks reached in 2007 or 2008, they have appreciated significantly over the past year or so as commodity prices have rebounded strongly.

In emerging Asia, pressures on some currencies to appreciate eased in mid November after indications that a number of countries may impose restrictions on capital inflows. Nevertheless, many of these currencies have appreciated against the US dollar over recent months, in part because of the improved performance of the Chinese economy. In contrast, the Chinese renminbi has remained broadly unchanged against the US dollar, and as a result depreciated over the past three months against most other emerging Asian currencies and in trade-weighted terms (Graph 30).

Australian dollar

After appreciating steadily over most of 2009 to reach a 15-month high in mid November of 94 US cents, the Australian dollar has generally traded in a wide range between 88 and 93 US cents (Graph 31). On a trade-weighted basis the Australian dollar has appreciated by over 25 per cent since the trough in March 2009. It is well above its post-float average against the US dollar and Chinese renminbi but remains below average against the Japanese yen (Table 5). The appreciation has been underpinned by the improved outlook for global growth and commodity prices as well as the relative strength of the domestic economy and the associated widening in interest rate differentials.

During 2009, movements in the Australian dollar were highly correlated with developments in global equity prices as shifting investor risk appetite was a common source of price movements. More recently, this correlation has fallen (Graph 32). Volatility in the exchange rate, as measured by the intraday range, is now well below the peaks seen in late 2008, although still above its long-run average (Graph 33).

Capital flows

Private capital flows have broadly returned to their pre-crisis configuration. Australian investors resumed investing in offshore markets in the June and September quarters of 2009 following two quarters of repatriating foreign investments (Graph 34). Foreign investment in Australia has also returned to pre-crisis levels, as the improvement in global market conditions in 2009 allowed Australian firms to raise offshore funding. However, the share of equity in net inflows is higher compared with the pre-crisis period, as corporations have sought to raise core capital and deleverage.