Research Dept. News
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Monthly Report, num 348 - July-August 2011
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Financial markets - Monetary and capital markets
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Turbulence returns
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A convergence of negative factors is punishing the markets.
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Four important factors have coincided between May and June to cause quite significant falls in stock markets and other risk assets, as well as a drop in yields of high yield sovereign bonds (in particular, those of the United States and Germany). Firstly, the shock regarding the United States' rate of growth within a difficult fiscal situation. Secondly, the sequence of restrictive economic policy measures applied in the emerging countries. Thirdly, the deterioration in the Greek sovereign debt crisis and, with regard to Spain, the impasse in the political and economic situation. And fourthly, the presentation of various proposals to tighten up regulations for the financial sector, in particular banking. The combined influence of these factors might be felt for some time yet but it should dissipate in the medium and long term, allowing the stock markets and interest rates to pick up again.
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With an imminent second hike in interest rates in the euro area, the Fed is maintaining its position
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Disparate strategies among central banks.
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Evaluated as a whole, economic indicators for the last few months make it clear that the world economic expansion is going through a slowdown, albeit temporary in principle. Inflationary risks resulting from rising commodity prices seem to have abated but not entirely. The intensity and context of this episode of economic moderation are very different depending on the geographical area and, consequently, so are the responses by the respective central banks. The Federal Reserve has opted to keep to its strategy of extreme lassitude, the ECB has implied that it will raise its official interest rate again in July and the authorities of the emerging countries have continued to apply a range of restrictive measures. For all of them, the challenge lies in finding the formula that provides sustainable economic growth rates and inflation in the medium and long term.
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The Fed asks the Congress to negotiate the legal debt limit soon.
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In the United States, the Federal Reserve (Fed) publicly announced its analysis of the economic scenario and its monetary policy strategy after its meeting held on 22 June. The institution's chairman, Ben Bernanke, acknowledged the importance of the current difficulties faced by the US economy, largely caused by the impact of Japan's earthquake and by rapidly rising commodity prices in the previous quarters. According to the assessment of the Fed's members, the influence of these elements should be temporary, resulting in economic activity reviving in the second half of the year. However, Bernanke also mentioned the structural problems that make this cycle very unusual: the deleveraging of households and the financial sector, as well as the paralysis in the real estate sector. In this respect, he acknowledged that the labour market is still refusing to show any sign of significant improvement, the main reason for the decision to keep the official interest rate at a minimum (0%-0.25%) and the commitment to continue with lax monetary policy for a long period of time. Similarly, Bernanke also repeated the institution's intention to terminate its quantitative easing scheme (QE2) at the end of June. To some extent, the new element in his speech was the announcement that, for the moment, the Fed will not extend the quantitative easing measures, thereby dissipating expectations of a possible QE3. However, what was very clear was the central bank's intention to keep the size of its balance sheet constant (reinvesting the interest and principal of public debt and mortgage bonds in portfolios) until conditions warrant otherwise. In short, Bernanke stated that it was still not the time to spell out its 'exit strategy' but neither was it the time to adopt a new quantitative easing scheme. He did warn of the need to redirect fiscal policy, expressing his concern given the situation of heavy borrowing that threatens the US economy if there are no substantial budgetary changes. In the short term, he asked for prompt negotiation in the Congress regarding legal debt limits which would provide the central bank with more room to manoeuvre.
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In the euro area, at its meeting on 9 June the European Central Bank (ECB) kept the official interest rate at 1.25%, as had been expected by analysts and economists. As has happened for several months now, the main focus of the monetary authority's message was its clear commitment to guarantee price stability in the region. Specifically, Jean-Claude Trichet stated that the institution is exercising 'strong vigilance' regarding trends in inflationary variables, an expression the institution tends to use as an advance announcement of imminent interest rate hikes. Given this circumstance, and in view of the policy normalization started by the ECB in April, the consensus of analysts estimates that, in July, there will be a second hike in the official interest rate up to 1.5%. With regard to non-conventional monetary policy measures, the ECB decided to retain unlimited one- and three-month liquidity facilities in response to the funding difficulties still faced by some banks in the region. With regard to its role in Greece's sovereign debt crisis, the ECB has adopted a flexible stance, accepting, together with the European Commission and the IMF, a possible solution consisting of public aid to Greece being complemented with the 'voluntary involvement' of private investors.
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The ECB has adopted a posture of 'strong vigilance' regarding inflationary variables.
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For their part, the monetary policy situation of the emerging countries is marked by their advanced stage in the economic growth cycle. The economies of these nations, characterized by achieving high rates of activity in the last few years, are suffering from the side effects of overheating: inflationary pressures, excessive growth in credit and the threat of asset bubbles (real estate and financial). Because of this, for months now these countries' central banks have been engaged in tightening up their monetary and financial policies, and there have been several signs of this once again in the month of July. Of note are the hikes in the official interest rate in Brazil and India, as well as the increase in the mandatory reserve ratio for commercial banks in China. The authorities' aim is to achieve a 'soft landing' for their economies: reduce inflationary pressures without harming growth too much. There are still too few elements to judge whether these policies are having the desired effect but the most recent figures suggest this might be the case, so that the process of adopting restrictive measures is likely to ease gradually.
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The expectation that the ECB will raise the interest rate in July has pushed up the three-month Euribor rate.
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Under the scenario described of disparate monetary policy strategies between the United States and the euro area, interest rates in interbank markets have moved in line with the trends in investors' expectations regarding the actions of the respective central banks. It's important to note other actions that were decisive in the past for interbank market volatility: namely the trend in risk premia for credit and liquidity. However, over the last few weeks the serious deterioration in the sovereign debt crisis in Greece has hardly led to rises in these premia, a remarkable and satisfactory state of affairs. Consequently, and as expected, the Libor interest rate in dollars has continued at rock bottom (in fact, setting a new record of 0.72% for 12-month maturities) as a consequence of the Fed's ultra-lax monetary policy continuing. Meanwhile, in the euro area, the statements made by Trichet and the almost certain rise in official interest rates in July have led to an upswing in the 3-month Euribor interest rate to 1.50%. On the other hand, the official rate for the 12-month Euribor remained stable at around 2.10%.
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Economic growth
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The bad economic figures for the United States lie behind the further fall in yields for the country's sovereign debt.
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The domestic yield rates for highest quality public debt (specifically of the United States and Germany, but also of other developed countries such as the United Kingdom and Canada) continued their downward slide in June. In the case of United States, yields for two and ten-year bonds fell to 0.38% and 2.90%, respectively. Of note among the factors underlying this new downturn in yields is the drop in activity for the second quarter of the year, greater than expected by analysts. This has aroused doubts in some investors regarding the economy's future growth. Secondly, the downturn in commodity prices has also been relevant, reacting to a series of factors, including some related to supply. In principle, both forces are temporary in nature, so that the fall in yields over the last few months is likely to revert in the medium term.
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Rating agencies warn of the impact resulting from Congress not reaching an agreement regarding the debt ceiling.
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In addition to these considerations related to the traditional duo of growth-inflation, in the US market scenario there are two special aspects of great relevance which, besides causing episodes of greater volatility, will also affect the steepness of the interest rate curve. On the one hand, there is the imminent end to the Fed's quantitative easing scheme (QE2) and, at an uncertain later date, the specifying of the 'exit strategy' to be adopted by the Fed to normalize monetary and financial conditions. On the other hand, there is the pressing agreement regarding the legal debt limit for the US Treasury. Given the importance of this issue, the three main credit rating agencies (S&P, Moody's and Fitch) have warned of the serious consequences of Congress not reaching an agreement on raising the expenditure ceiling, not only from the point of view of its public debt rating but (and even more importantly) regarding the US and the world economies.
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In the case of the euro area, yields of German sovereign debt performed similarly to that of the United States. The yields of two and ten-year bonds fell to 1.40% and 2.85% respectively, the latter being the lowest level since the beginning of the year. The euro area's current economic situation, seriously affected by the worsening of the Greek sovereign debt crisis and fears of this infecting other countries, is causing a 'flight to quality' in investor preferences. This behaviour should be temporary, giving way to the influence of a medium and long-term economic scenario with favourable foundations for growth and inflation for the area. In terms of the debt markets, this would result in a rise in yields for the central countries' bonds.
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The Greek sovereign debt crisis has led to a 'flight towards quality'.
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For its part, the deterioration in the sovereign debt crisis in Greece has led to further increases in the spread between the debt of the countries of peripheral Europe and German debt. The complex nature of the agreements between the troika (IMF, ECB and the EU) and the Greek government when designing the aid package, and the delicate domestic situation of the Greek parliament, are the main obstacles to emergency funding arriving quickly. The issue most extensively debated by these authorities is the possible application of a 'reprofiling' of Greek sovereign debt, allowing the private sector to take part.
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The spread between Spain and Germany's sovereign yields registers tensions, albeit contained at present.
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In the case of Spain, the complication of the Greek crisis, speculation regarding the cost of a possible rescheduling of its debt for Europe's banking sector as a whole, plus the climate of impasse perceived in Spain's economic and political situation have helped to push its sovereign risk premium above 275 basis points. However, in spite of these notable upswings, Spanish debt still enjoys a relatively more stable performance in comparison with the rest of the countries of peripheral Europe.
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Volatility dominates the dollar-euro exchange rate
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Once the current ups and downs have been overcome, the dollar is likely to appreciate against the euro.
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The aspect that has characterized the dollar exchange rate against the euro in spring has been high volatility. Throughout this period, the exchange rate fluctuated within a range of 5%, the highest being 1.49 dollars and the lowest 1.40. This performance is the result of several factors occurring together. Initially, factors that pushed up the euro dominated, such as the interest rate hike by the ECB, the capital inflows in euros and the worrying situation of the legal debt limit in the United States. Subsequently, the worsening of the Greek debt crisis, the fear that this situation would infect other economies in the euro area and the drop in price of some commodities have acted as a catalyst for the dollar to appreciate. In any case, in the medium term, and once the current ups and downs have been overcome, the most probable course of action is for the dollar to appreciate gradually as the differential between the Fed and ECB interest rates narrows.
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Corporate bonds attempt to withstand adversity
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Although stock markets remain weak in June, the medium and long-term outlook is good.
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Although they have not been immune to the four negative factors mentioned previously, corporate bonds continue to perform relatively well. In fact, during the last quarter this market showed commendable strength given its successive adverse shocks (including Japan's earthquake and the Middle East conflicts). In June, the balance is still acceptable thanks to the rises in risk premia being partly offset by the fall in official interest rates (i.e. those of high yield public debt), resulting in moderate losses in the extensive corporate bond indices. However, as a consequence of the globalization of the economy, financial markets are not entirely impervious to what is happening elsewhere, so some signs of contagion in the credit markets have been observed. In the case of the euro area, the sharp rise in sovereign debt risk premia of the peripheral countries has affected credit spreads in the financial sector, which is highly exposed to Greece's problems. But in spite of this movement in the sector's spreads, we must insist that the price variation in corporate bond indices has hardly moved. A similar situation has occurred in the high yield bond sector, mainly in the United States: the rise in risks resulting from a possible slowdown in economic growth has widened spreads, although without harming the indices. Within such an environment, and apparently as a reaction to the deterioration in the global situation, two facts have occurred that are certainly temporary in nature. The first is the reduction in issuance for developed markets in the last few weeks of June. And the second is the gradual reduction in flows of funds towards corporate bonds, given the prudential action of managers who are opting to increase the liquidity positions in their portfolios.
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Correction in the stock markets
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The main international stock market indices have continued to perform weakly throughout June and we can clearly observe the negative effects of the different factors mentioned previously in these markets.
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Confident that the obstacles to the current financial situation are temporary in nature and can be resolved relatively satisfactorily, the outlook for the stock markets in the medium and long term is favourable. The main arguments that will serve as support for equity revolve around world and business growth picking up again and credit risk falling. But in the short term, the stock market scenario is showing signs of weakness and volatility which, combined with seasonal factors, might result in further corrections throughout the summer.
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The most evident case is that of the United States. In addition to the symptoms of overbuying identified in US stock markets in spring, we should also add the decline observed in economic, sentiment and flow indicators. Moreover, the trends in these stock markets might be temporarily affected by the end of the QE2 and, logically, by the political negotiations on budgetary adjustment, which might lead to a drop in 'risk appetite' among investors.
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In the euro area, the financial sector is being strongly affected by European banking's high exposure to Greek sovereign debt.
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In the case of the euro area, although the future prospects look good, the deterioration in the Greek sovereign debt crisis and the complex search for solutions are increasing the feeling of uncertainty and fear of possible contagion to other economies in the region. Given this situation, the financial sector is currently the most severely hit in the markets, due to European banking's high exposure to peripheral public debt. Another factor also weighing heavy on the banking sector is the intense flow of news and rumours regarding regulation reform, particularly concerning solvency and liquidity requirements. In this respect, capital increases and the containment of dividends are elements that, at least in the short term, are having a negative effect.
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Emerging stock markets post a downward slide due to monetary and fiscal normalization.
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Lastly, the stock market situation of the emerging economies over the last few months has been characterized by a downward trend, the consequence of tightening up monetary and fiscal policies. Although inertia is still negative in the short term, in the medium term the confirmation of these economies enjoying a soft landing and a reduction in inflationary pressures will be positive for their equity.
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