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The ECB buys bonds and sterilizes, while the Fed moves forward in its exit strategy
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The ECB sees the outlook as positive for business but is more cautious about inflation trends.
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As already happened in April, in May investors' attention focused on the strong tensions concerning Greece's sovereign debt and the potential negative implications if its spread to other countries was not contained in time. For this reason, the markets expected that, on 6 May, the day of the meeting of the Governing Council Central European Bank (ECB), some measure or pronouncement would be announced aimed at normalizing the functioning of the markets. However, the reserve bank communicated that it was maintaining its official rate at 1% and its president, Jean-Claude Trichet, stated that they had not discussed the possibility of intervening in the markets by buying up government bonds.
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In the post-meeting press conference, Trichet added that the European Central Bank's non-standard monetary policy would remain unchanged in all its aspects. Moreover, the ECB president stressed that market trends were no obstacle to continuing with the gradual withdrawal of monetary stimulus.
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The ECB keeps its official interest rate at 1%.
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Regarding the economic perspective, the ECB gave a more positive view of the recovery in business, supported by global growth and foreign trade. On the other hand, although Trichet said that inflationary pressures were expected to remain contained in the euro area, he also stated that there was a risk of importing inflation due to rising commodity prices.
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On 7 May, the high uncertainty and volatility reigning in the markets led to a spectacular fall in the price of Greek sovereign debt, which also infected the public debt of Spain, Portugal, Ireland and Italy, albeit to a lesser extent. This resulted, on Monday 10 May, in an unprecedented coordinated effort, with the governments of the euro area together with the ECB announcing a series of measures aimed at safeguarding the region's financial stability.
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Among the different measures, of note is the ECB's decision to start buying up government and private bonds to ensure the markets function properly. Trichet also announced that liquidity resulting from bond purchases would be re-absorbed via fixed-term deposits. In this respect, on 18 May the ECB carried out a tender for deposits in which it accepted 16.5 billion euros at a marginal interest rate of 0.29%, thereby counteracting the total amount of bonds purchased up to 17 May.
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The ECB's buying of bonds is being complemented by deposit tenders to sterilize the liquidity resulting from these operations.
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Other measures taken by the ECB affected the agenda for refinancing operations at three and six months and dollar liquidity. Firstly, on 12 May, another 6-month tender was carried out at a rate fixed at the average minimum bid rate of the weekly tenders, allotting 35.688 billion euros among 56 commercial banks. Secondly, the 3-month tenders, which will be carried out in May and June, will once again adopt a full allotment procedure and a fixed interest rate of 1%. Lastly, the ECB resumed the swap line in dollars with the Federal Reserve (Fed) to provide financial institutions in the euro area with dollar liquidity.
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On the other side of the Atlantic, the most interesting news regarding the Fed was related to its non-standard monetary policy, and in particular fixed-term deposits. The central bank has communicated that, in mid-June, it will start to test, on a small scale, the functioning of the term deposit facility. This is one of the instruments that will be used by the institution when it starts to drain excess reserves from the financial system. The test will consist of auctioning five operations, at a fixed interest rate and a maximum term of 84 days.
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There have been no substantial changes in its standard monetary policy. At least this was implied by the latest statements given by the Fed governors of Dallas and Minnesota, Richard Fisher and Narayana Kocherlakota, respectively. Both governors presented a positive view of business but always indicating that the monetary authority believes it is still too early to raise the official rate.
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The United States' greater financial stability can be seen in the trends in its interbank curve.
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The latest financial incidents have increased disparity in the behaviour of interbank markets in the euro area and United States. The US interbank curve has risen 16 basis points on average (100 basis points are 1%), and its slope (the difference between the 12-month and 1-month rate) has risen by 9 basis points. This behaviour does not seem to be due to financial tensions but rather to the United States being at a later stage in the recovery cycle.
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On the other hand, the apparent stability of the interbank curve for the euro area, which has only risen 3 basis points on average, occurs within a context of a market with certain operational problems. In this respect, the ECB's emergency measures to provide liquidity reveal a lack of confidence among the financial institutions of the euro area. This situation suggests that the slight upward trend in yield, which was expected for this market a few months ago, will take a bit longer to materialize.
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Government bond markets: a rush for quality
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Risk aversion increases in government bond markets.
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During the month of May, the rise in risk aversion in the euro area's government bond markets became extreme. The greater uncertainty regarding governments' ability to meet public debt payments, such as Greece, Portugal or Spain, significantly widened the differentials between Germany and these countries.
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Investors, gripped by the fear of default or restructuring, transferred their money towards the government bonds of countries such as the United States and Germany, considered to be a safe haven when panic reigns supreme, such as in the last few weeks.
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The approval of the Greek bailout plan is complemented with the creation of a stabilization fund in the European Union.
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The approval on 2 May of the bailout plan for Greece, totalling 110 billion euros, initially appeared to stop the situation from spreading to the rest of the peripheral countries. But this green light for the plan didn't manage to calm the markets for long. One example of the state of nerves could be seen in the differential between Spanish and German bonds with 10-year maturity which, since 23 April, has widened from 0.83% to a maximum of 1.64% recorded on 10 May.
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Given the serious turn taken by events, and the sharp rise in volatility in financial markets, the European Union adopted a significant fund of financial aid for members in difficulty. This consists of the creation of a stabilization mechanism provided with 750 billion euros. Moreover, as has already been mentioned, the ECB undertook to buy government bonds to unblock some markets.
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Investors take refuge in the government bonds of Germany and the United States.
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The extent of these measures had a calming effect and managed to slightly reduce the differentials between Germany and the peripheral countries, although still at levels higher than those before the crisis erupted. Thanks to its status as an asset safe haven, German debt with a 10-year maturity has slipped below 3%, at the end of May offering a yield of 2.74%.
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Movement was also intense in the United States treasuries. While the economic data continue to endorse a slight improvement in this country's economic situation, 10-year US bonds, which offered a 3.65% yield at the end of April, were only providing a return of 3.31% one month later. This lower yield reflects the significant tensions experienced in international financial markets and the strong demand for North American Treasury bonds, in which investors decided to take refuge.
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Germany bans the naked short-selling of EU government bonds.
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On 19 May, the Federal Financial Supervisory Authority in Germany (BaFin) announced that, as from that date and up to 31 March 2011, it was banning naked short sales of debt securities of euro area countries. It has also banned uncovered credit default swaps (CDS) in which the underlying asset is a government bond of a euro area country, if it is not the owner. CDS are similar to insurance against default risk for the underlying asset on which the product has been taken out. BaFin justified this measure by referring to the extraordinary volatility of debt securities of countries from the euro area, which is jeopardizing the stability of the financial system.
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In the medium term, and as tensions ease, the differentials between the debt of Germany and peripheral countries should decrease.
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Government bond markets are still highly volatile and the next few weeks will be very important in recovering stability after the significant measures announced, both at the level of the European Union as a whole and also in the various countries that are carrying out budget adjustments. We cannot rule out some moment of tension during this period. But in the medium term, and as the economic data continue to confirm global economic growth, the differential between Germany and the peripheral countries will tend to stabilize and even decrease within a slightly upward context of the yields offered by sovereign debt.
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The euro is still tending to lose value
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The euro depreciates significant during the month of May.
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The other financial asset that has suffered severely at the hands of the volatile markets has been the euro. In the midst of extreme statements by numerous international economists and investors, who were even setting a date for the disappearance of the single currency, the European Union has decided, in the words of the EU Commissioner for Economic and Monetary Policy, Olli Rehn, that «we shall defend the euro whatever it takes».
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But in spite of all the measures taken, the euro has accelerated its depreciation against the dollar, started at the end of November last year when one euro was worth 1.50 dollars. It is currently worth 1.23 dollars, depreciating approximately 8% in the last month alone.
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The different stages in the economic cycle of the United States and the euro area favour the dollar.
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Two factors can explain the violent movement experienced by the euro. Firstly, economic fundamentals have boosted the dollar. In other words, the differences in growth perspectives and interest rates between the United States and the euro area have led to the dollar appreciating against the euro. In such an environment, it's normal for the demand for dollars to increase in detriment to the euro, in order to acquire North American financial assets, both fixed income and equity.
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Institutional investors have increased positions that benefit from a depreciating euro.
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Secondly, the higher perceived sovereign risk in periphery countries of the euro area has led to intense movement in the portfolios of international investors. Hedge funds, for example, have increased positions that benefit from a depreciating euro and investors have reduced the proportion of assets in euros to contain the risk in their investment portfolios.
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Although the continuation of the economic fundamental factors that favour a depreciation of the euro will continue to encourage such movement, after the recent exceptional intensity we cannot rule out the euro appreciating in the short term, at least partially. For this to happen, the decisions taken by the European Union must help to restore confidence in the project of the single currency.
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The sovereign debt crisis in Europe is hindering corporate debt
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The sovereign debt crisis hits private debt, particularly financial institutions.
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As already mentioned, the sovereign debt crisis of several countries in the euro area has become a crisis of confidence in the euro or, put another way, the inability of the European Union to manage economic and financial imbalances. As a result, risk premia have substantially risen in the private bond market.
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Once again, the financial sector is the most affected and the risk premia of some institutions have widely exceeded the maximums recorded in the Lehman Brothers crisis. On the other hand, risk premia have risen notably in large firms and sectors with regulatory risk, such as energy, telecommunications, etc. and those exposed to public investment. In general, firms with high debt levels are suffering a highly significant deterioration in their net lending and are facing notably more expensive credit.
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Logically, firms located in those countries causing this financial instability are suffering from much more expensive and, of course, much more scarce credit in international markets.
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The crisis reaches the high yield bond market and threatens to paralyze the deleveraging of venture capital funds.
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In the last few weeks, this uncertainty has jumped from Europe to the United States and has even reached some emerging markets. The high yield bond market, representative of those firms most sensitive to trends in the economic cycle, has ended up suffering more sharply from the effects of contamination.
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The negative effects for capital markets are also being felt in the activity of the venture capital market in the United States which, taking advantage of the high level of liquidity in the markets in the years before the crisis started, got into debt by buying firms with great financial leveraging. The debt that must be refinanced over the next few years totals 2 billion dollars.
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Within this uncertain environment, there has been a rapid fall in activity in Europe with a drastic reduction in new issues and a drop in transactions in secondary markets. The volume of business remained stable in most sectors in the United States, but in the last few weeks there has been a fall in activity in the primary market, although no excessive reduction in the level of operations has been seen in the secondary market.
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Rating agencies confirm the different expectations for American and European firms.
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Credit rating agencies, distanced from the turbulence of the markets, offer a very clear portrait of the trends, with a notable improvement in the ratings of corporate debt in the United States; unlike those of the euro area, where the positive to negative rating ratio has been moving at the lowest levels in the last ten years.
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Doubt reigns supreme in the stock markets
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Equity has performed negatively during the month of May. The uncertainty generated by the sovereign debt risk of some euro area countries has clearly contaminated equity markets, although with varying intensity. The European markets have suffered the biggest drop with monthly reductions of close to 10%. Meanwhile, the repercussions are less severe in the US and emerging country stock markets thanks to the good performance of their economies, as shown by their improved business margins. But the effects of the crisis are filtering through to equity via the depreciation of the euro's exchange rate.
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Risk aversion has been reflected in the sharp increase in volatility of the stock market indices, accompanied by institutional investment flows fleeing from equity towards other, lower risk alternatives.
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Stock markets crumble due to concerns resulting from the sovereign debt crisis.
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Equity investors appear to be greatly concerned about the financial sector, only comparable with the situation experienced in 2008 with Lehman Brothers, and due to two aspects. Firstly, the European sovereign crisis has increased uncertainty regarding financial institutions, since they have around 10% of their national government's debt on their balance sheets and also hold debt from other countries in the euro area. And, secondly, the debate is still raging in the United States on how to regulate the financial system, the proposal being to redefine the operational rules in order to protect the sector from further crises.
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Upswing in the volatility of equity markets and risk premia.
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In the last few days, Germany has made an unexpected about-turn regarding the financial markets. Given the strong volatility in the German stock market, the German financial market supervisory body has imposed a temporary ban (until 31 March 2011) on «naked» sales of shares of the country's top ten financial institutions.
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Germany bans short selling in order to protect the euro.
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In spite of this scenario today, the medium term outlook for equity is still good, thanks to the recovery in economic activity. But in the short term, given the highly vulnerable financial markets and the lack of confidence in the measures being implemented by politicians on both sides of the Atlantic, there may still be a period of erratic movements within a context of high volatility.
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