Research Dept. News
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Monthly Report, num 350 - October 2011
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Financial markets - Monetary and capital markets
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Hard times
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The slowdown in world economic growth affects the financial environment.
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For months now, the current financial panorama has been dominated by a series of risk factors that are causing, in addition to the now familiar movement of capital flows towards high quality assets, a gradual deterioration in conditions to access financing for numerous agents. Among the most significant risks are the lower economic growth prospects at a global level, the temporary delay and geographical spread of the sovereign debt crisis in the euro area, as well as the different actions taken by the monetary authorities of emerging countries to allay the danger of their economies overheating and a subsequent brusque landing.
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Certainly, the effects of these factors, with the different approaches and economic policies used to tackle them, will continue to determine the performance of financial markets in the short term. With sufficient perspective and, as the present setbacks dissipate, the conditions for financial conditions should improve, supported by the expansionary economic growth cycle and restored investor confidence.
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Central banks react to the economic slowdown
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Monetary policy strategies differ depending on the country.
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For the last few months, the world economy has been showing clear signs of moderating its rate of growth. March's adverse shocks gave way to a new stage in the global economic cycle, characterised by a moderation in activity, a situation that was initially meant be temporary and limited in nature. This process is at different stages of maturity depending on the geographical area, as is also the case with inflation rates, closely linked to rising commodity prices at the end of 2010. That's why the different central banks are using different monetary strategies based on the objectives they have defined and the conditions perceived in their areas. However, in the last few months the common denominator is a growing sensitivity of central banks to the risk of the slowdown being more intense than desired and ending up in recession, especially given the doubts regarding the situation of the balance sheet (indebtedness) of various countries and financial institutions.
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The Fed adopts more measures to boost economic growth.
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In the United States, the Federal Reserve (Fed), after its Monetary Policy Committee meeting on 21 September, presented the conclusions of its analysis of the current state of the economy and the new guidelines for monetary policy it had agreed. Fed chairman, Ben Bernanke, once again referred to the weak phase the economy is currently going through, highlighting the small number of advances observed in the last few months in the main indicators for activity and private demand. He also confirmed that, given this scenario, the Fed believed that prospects for job creation were modest, predicting that the unemployment rate would remain at a relatively high level for the next few months. Based on these circumstances, and as already suggested in August, the Fed decided to keep interest rates within the lowest possible range (0%-0.25%).
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The Fed will restructure its Treasury bond portfolio in order to keep long-term interest rates low.
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In addition, the Federal Reserve also introduced a new instrument in its monetary policy strategy, the so-called «operation twist». Specifically, the central bank has undertaken to buy up Treasury bonds with long-term maturities (between 6 and 30 years) for the sum of 400 billion dollars up to June 2012 and to sell government debt at 3 years or less. With this instrument, previously used by the Fed in the 1960s, the institution aims to reduce long-term interest rates and to make financing conditions more flexible for households and firms. The Fed also confirmed that it would continue to reinvest the interest and principal of the public debt and mortgage loans it currently holds in its portfolio. These measures highlight that the institution's proposal is to provide monetary conditions that are as lax as possible, postponing sine die any debate about its «exit strategy».
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The ECB revises downwards its growth estimates for the euro area.
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In the euro area, the European Central Bank (ECB) opted to keep the official interest rate at 1.5% after its meeting in September. As in his previous appearances, the central bank's president, Jean-Claude Trichet, referred to the adaptable nature of monetary policy, as well as confirming the start of a slowdown in the region's growth for the second quarter. In the words of Trichet, the current risks involved in Europe's situation (resulting from the peripheral sovereign debt crisis and the fiscal adjustments implemented in most member countries) are pushing growth down in the euro area, so the ECB has revised downwards its growth estimates for the area for 2011 to the range of 1.4% to 1.8%. With regard to consumer price stability, the main aim of monetary policy, the president admitted that the risk of further rises in inflation has eased in the medium-term, although he predicted that the general rate will remain above 2% for the next few months. This kind of statement suggests that the ECB will halt its series of official interest rate hikes which started in April. In fact, the monetary market expects that, before the end of the year, the ECB will have cut rates by half a point. This is certainly an aggressive prediction but it cannot be completely ruled out if the economic slowdown continues and market tensions become even worse.
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The emerging countries halt their monetary tightening.
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In this respect, and in the area of the unorthodox monetary measures, the ECB decided to keep the existing mechanisms (unlimited liquidity facilities at 1 and 3 months, plus a special facility at 6 months) in response to the funding difficulties being faced by many of the region's banks as a consequence of the sovereign credit crisis. In addition, during September, and pressurized by the scarcity of funding in dollars, the ECB announced, in a joint action with the Federal Reserve, Bank of England, Bank of Switzerland and the Bank of Japan, that it would provide liquidity (also a limited amount) in dollars at three months for those European banks that require it. With regard to the ECB's work in resolving the crisis, the central bank's commitment is still total. In addition to playing an active role in the Troika negotiations (together with the European Commission and the International Monetary Fund) in aspects such as the bail-out packages for economies in difficulty and the enlargement of the European Financial Stability Fund's powers, the monetary authority has also continued with its programme to purchase the sovereign bonds of peripheral countries. Although the initial aim of this programme was to make selective purchases to sort out temporary dysfunctions in the debt markets, since August these purchases have become unexpectedly regular and large. This is due to the higher risk of the crisis spreading to economies such as Spain and Italy. Disagreement regarding this action in the debt markets was precisely the cause of the resignation of the ECB's head economist, Jürgen Stark.
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The dollar interbank market deteriorates slightly given the tensions in the euro area.
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For their part, the general profile of the monetary policies adopted by the emerging countries continues to be restrictive. Over the last few months, the phase of the economic cycle in which these countries find themselves, more advanced than the one for developed economies, has required a more determined and faster normalization of interest rates and, in many cases, the use of alternative instruments to contain the rise in consumer prices, the increase in credit and the formation of price bubbles in some assets. However, since the spring, signs have started to emerge of moderation in the growth of activity and credit in most emerging economies which might be the first steps towards their «soft landing». This indicates that the cycle of monetary tightening should be coming to an end, giving way to a phase of stability or even the application of some relaxation measures. This is the case of Brazil, whose central bank decided to lower interest rates (50 basis points to 12%) with the first references to slowdown in economic growth and although its rate of inflation is still very high.
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Within this context of unequal monetary strategies between the United States and the euro area, interbank interest rates have reflected the expectations of investors regarding the actions of the respective central banks, as well as the outcome of the European sovereign debt crisis. In the United States, the Libor interest rate in dollars rose slightly, continuing the trend started in July. Both the three-month and one-year rates reached their maximum level since the start of the year, the highest level in the last twelve months. The main reasons behind this gradual rise in interest rates are, on the one hand, the worsening sovereign debt crisis in Europe (especially the delicate financial situation of Greece) and, on the other hand, the difficulties faced by European banks to secure funding in dollars (up to mid-September, when the ECB communicated its proposal to offer unlimited financing in dollars).
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European banks resort more to the ECB for funding.
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Interbank interest rates in the euro area (Euribor) are going through a relatively stable phase. After having reached its highest level since February 2009 (2.20%), in August the twelve-month Euribor started a slight downturn, which continued with slight falls in September. This circumstance has largely been motivated by lower world growth expectations, which investors believe will also end up affecting the euro area, in turn suffering the shock of the debt crisis, and might lead to a change in the ECB's monetary policy strategy. The difficulties being faced by European banks to secure funding in the wholesale markets, either the interbank or the bond markets, have pushed up demand for ECB loans. In fact, the amount requested has been greater than immediate needs, thereby leading to surplus liquidity that has resulted in a rise in the ECB's own deposit facility balance. This factor is pushing down very short-term interbank rates, such as the EONIA.
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The slowdown in growth is pushing down yields on high quality public debt
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The Fed's actions in the debt market are pushing down long-term yields.
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Continuing the process started last spring, yields on the public debt of leading economies, specifically the United States and Germany, have continued to accumulate drops during September. In fact, the most relevant note for the debt markets on both sides of the Atlantic is the fall in yields to record lows. In the case of United States, the yield on two-year bonds fell to 0.15%, compared with 0.85% in April. For its part, the yield on ten-year bonds fell for the first time below 2%. There are principally two aspects responsible for the increasingly widespread falls in yields. The first is the persistent weakness observed in economic indicators at a global level. The second is the action taken by the Federal Reserve as a buyer in the bond market. To these two factors we should also add the effect of growing investor concern in the US debt market regarding developments in the euro area's sovereign debt crisis. This is causing a «flight to quality» that is benefitting assets issued by the US Treasury, in spite of the low yields. For the most immediate future, the key factor will be the effective implementation of the Federal Reserve's decision to act as a participant in the debt markets, buying titles with long-term maturities and selling them short, which should continue to push down the interest rate curve.
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In the case of the euro area, the yield for German sovereign debt has behaved similarly to US debt. The yields on two and ten-year bonds continued to accumulate drops, falling to 0.48% and 1.81%, respectively. As has been happening for a few months now, the worsening sovereign debt crisis in the periphery of the euro area looks like the main reason why investors have continued to show their preference for this kind of asset over those with a riskier profile.
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Fear of a possible Greek default is hitting Greek debt hard.
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For its part, the risk premia of peripheral countries have performed erratically throughout the month. The main symptom of this behaviour could be seen in the dramatic rise in yield of Greece's short-term bonds (going above 70%) given the increase in rumours of a possible «controlled default» of the Greek economy. On the other hand, the spreads in yields for Italian and Spanish debt compared with Germany were more stable (within the exceptional parameters of the current crisis), partly thanks to the ECB buying up the debt of these countries, although the persistent lack of investor confidence in the structural reforms adopted by both economies continues to stop spreads from getting back to normal.
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The Swiss franc pegs its exchange rate to the euro
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Expectations of lower economic growth in the euro area weigh heavily on the exchange rate compared with the dollar.
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Within this scenario, the exchange rate of the dollar against the euro has been subjected to a high degree of volatility. The underlying trend has been a weak euro or a strong dollar (which has appreciated in general against a number of international currencies). In fact, the European currency has fallen below the barrier of 1.40 dollars for the first time in six months, quickly reaching 1.35. As has been happening for some months now, the euro-dollar exchange rate has been subjected to various forces, all simultaneously working against the former: the slowdown in global economic growth prospects, which in the last few weeks has led to more nasty surprises in the euro area; the expected reduction in the ECB official interest rate; the ups and downs of the sovereign debt crisis in the euro area and the risk of this spreading to the rest of the economies in the region and their financial institutions. In this respect, one decisive event for the relationship between both currencies was the ECB offering unlimited financing in dollars to European banks as from October.
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The National Bank of Switzerland caps the exchange rate between the euro and the Swiss franc.
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Another relevant fact for the foreign exchange markets was the pegging of the Swiss franc exchange rate to the trend in the euro's price. In an effort to slow up the appreciation of its currency and to protect the interests of its exports, the National Bank of Switzerland announced that it will intervene as much as required to avoid depreciation beyond 1.20.
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Investors choose to take refuge in investment grade bonds
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High quality bonds act as a safe haven.
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As in previous quarters, the performance of corporate bonds has been more stable than other markets given the scenario of a slowdown in world growth and the worsening debt crisis in Europe, although some sectors have started to suffer negative effects on their indices. In September, and breaking the trend observed over the summer, the main corporate bond indices fell slightly due to a widespread upswing in risk premia. On this occasion, the rise in premia accelerated after the Federal Reserve confirmed that it expected economic growth in the United States to slow up.
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High yield bonds deteriorate.
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However, in spite of the slight correction in indices, corporate bonds have continued to act as a safe haven, behind gold and the public debt of the most solvent countries (such as the United States and Germany). Specifically, investment grade corporate bonds, both of the United States and the euro area, as well as some selected bonds from the emerging economies, have once again recorded slight increases in demand and consequent drops in their yields. In the case of the euro area, the indices of investment grade bonds, in spite of a relatively favourable performance, are still being affected by the debt issued by banks. The recent downgrades by rating agencies for the main French and Italian banks have added tension to bank-issued debt, with their risk premia reaching a record high. For its part, the high yield sector (bonds with a high yield and high risk), which in previous quarters a favourite destination for investors, has started to see an increasing decline giving the rising fear of a strong downturn in economic growth, implying higher bad debt and default rates.
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Given this financial situation, companies in developed countries have been issuing fewer bonds. The lack of opportunities to sell their bonds in the markets is leading to a growing number of firms, mainly financial institutions, opting to use covered bonds as a means to obtain wholesale financing.
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Uncertainty dominates the stock markets
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The markets punish the bonds of European banks.
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International stock markets have looked fragile and erratic throughout September. The world's worsening economic growth prospects and the perceived unstable financial scenario have been reflected in the upswing in volatility and movements in investor flows. The latter have continued to transfer their capital to assets with a less risky profile, such as gold, high quality corporate bonds and the public bonds of Germany and the United States.
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International stock markets show a high degree of uncertainty.
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Assuming that the risks of the current economic and financial situation are gradually going to be resolved satisfactorily, the medium and long-term outlook for the world's stock markets is favourable. In this respect, in spite of the negative effect of the risks on profit forecasts made by analysts, the fundamentals for stock market gains are still the same. These include a recovery in the world's sustained growth cycle, resistance of the expansionary business cycle and a reduction in credit risk. However, in the short term investors are very sensitive to the risks to growth and the European sovereign crisis, a huge obstacle to potential stock market gains being realised.
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The resolution of the current financial uncertainty should give way to a more favourable period for equity.
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In the United States, the weakness of economic indicators, fears of a possible double dip recession in the US and the as yet incomplete political negotiations regarding the deficit ceiling are the main obstacles challenging stock market indices. However, estimates by the consensus of analysts see as quite moderate the impact of current risks on the profits forecast for the coming year, expecting margins to be sustained within the financial scenario of the coming quarters.
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In Europe, in addition to growing uncertainty due to the debt crisis possibly spreading to other countries, there is also uncertainty caused by the recapitalization requirements that would be faced by European banks in the case of Greek default. This is precisely why banks' shares are still in the sights of investors, reinforcing this punishment after the downgrading suffered by some French and Italian banks.
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The banking sector loses ground as a consequence of the European sovereign debt crisis.
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The stock markets of emerging countries have also suffered from the effect of the sovereign crisis, albeit to a lesser extent. The stock markets of these economies are still immersed in a circle of corrections caused by tougher monetary policies and the initial signs of a slowdown, the implications of the European debt crisis being an additional burden on any attempt at recovery made by their indices in the short term.
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