Research Dept. News
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Monthly Report, num 360 - September 2012
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Financial markets - Monetary and capital markets
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Awaiting events
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Greece, Spain and the slowdown in world growth attract the attention of the markets.
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The summer has been characterized by a tense wait for impending decisions to be taken in the euro area crisis. Greece and Spain are the main focuses of attention. Greece has asked for more time to apply the adjustment and reforms it is committed to, but its European partners will not announce their decision until September. Spain is pending the implementation of the already agreed bank bail-out terms and conditions, with a schedule that also becomes more intense as from September. The slow materialization of the European Council agreements of 29 June regarding «banking union» and the ECB's reluctance to intervene in sovereign debt markets have increased investor concerns. There are also the evident difficulties of Spain's economy to reduce its public deficit, forcing the adoption of further fiscal measures with an uncertain effect. As a result of these circumstances, global investor attention is focused on whether the Spanish government will finally ask the European bail-out fund for a second and more extensive aid programme.
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Meanwhile, the slowdown in the pace of global economic activity and the deterioration in growth prospects for the next two years are also hindering the financial markets. On the other hand, over the last few weeks the hope has grown among investors that central banks may employ further quantitative measures to sustain and, if possible, boost the weakened economic and financial pulse worldwide.
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Monetary authorities are shuffling their cards
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Most central banks are relaxing their monetary policy.
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Central banks play a crucial role in the current economic and financial scenario. Under the premise of securing financial and economic stability, monetary authorities are making their policies clearly expansionary, based on the use of various instruments of an extraordinary and innovative nature. At the same time, to reinforce the results of their actions and ensure they last, central bankers are also relentlessly calling for a contribution from political leaders in the form of ambitious structural reforms and far-reaching fiscal adjustments. This is clearly the case of the euro area and of the United States.
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The ECB lowers official interest rates to record levels.
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During the months of July and August, the actions of the European Central Bank (ECB) have occupied a large part of the headlines in global financial markets. The exceptional rise in the sovereign risk premium for several countries on the periphery and the deterioration in growth prospects for the region have led the ECB Council to adopt particularly significant measures. Of note among these, firstly, is the historical lowering of the official interest rate to 0.75% and the deposit facility interest rate to 0%. With both cuts, the ECB's aim is to relax general monetary and financial conditions, improving the efficiency of the mechanisms to pass on credit in the euro area. By lowering the official interest rate, it hopes to reduce financing costs in the long and medium term, while the reduction in the deposit interest rate aims to boost interbank market activity.
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The ECB will only purchase peripheral public debt after a prior request from the countries to the EFSF.
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The second significant measure has been the announcement of the ECB's official position regarding its intervention in the debt markets for peripheral countries. This has been a key debating point over the last few months and the confused communication policy of ECB President, Mario Draghi, has had considerable impact on global markets. In principle, and as part of an unofficial conversation, Draghi made the following statement on developments in the euro area crisis: «Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And, believe me, it will be enough». Financial markets reacted immediately to his words, setting off a process of narrowing spreads for Spanish and Italian sovereign debt compared with Germany. But this optimism didn't last long. After the regular meeting of the ECB's Governing Council, Draghi stated that there are strict conditions for the ECB's actions. Specifically, the institution will be prepared to buy up countries' sovereign debt provided their governments have previously asked for help from the current European bail-out fund (EFSF/ESM). He also said that, should they intervene, the sovereign debt purchases would focus on the short part of the curve; in other words, maturities of between 1 and 3 years. Although this has brought about a considerable reduction in yields on Spanish and Italian 2-year bonds, it has not been well received by most observers who believe that certain aspects still need to be spelled out, such as how much debt would be bought and under what terms it will interact with the EFSF/ESM.
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The ECB urges European governments to continue carrying out fiscal and structural reforms.
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In any case, the ECB continues to encourage governments in the euro area to adopt the necessary fiscal and structural measures to achieve a greater degree of stability and competitiveness. For its part, the ECB has undertaken to collaborate in designing and implementing the route map for «banking union», which would include the creation of a single supervisory bank and the possibility of giving bail-out funds more flexible powers (as concluded in the European Council of 28 and 29 June).
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The Fed keeps to its monetary strategy with the aim of sustaining economic growth.
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In the United States, the Federal Reserve (Fed) has kept to its monetary policy after the extension of the «Operation Twist» announced in June. According to Ben Bernanke, the head of the central bank, the figures gathered during the first half of the year point to domestic economic activity slowing up at a faster rate than initially estimated. The modest advances observed in the main indicators (private consumption, investment and employment) suggest that the level of growth for the next few quarters will remain around 2.5%. But those in charge at the Fed have also identified two clear risk factors that might compromise growth prospects. One is the worsening of the sovereign debt crisis in the euro area and the other is known as the «fiscal cliff». If the two parliamentary groups don't reach an agreement in this respect, on 1 January 2013 there will be automatic fiscal contraction as the fiscal cuts from the Bush era will have expired. It is estimated that this phenomenon could lead to a sharp fall in the United States' gross domestic product (GDP), channelled via a drop in public expenditure and an increase in the tax burden.
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Many analysts expect the Fed to use other monetary stimuli.
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Based on these factors, the Fed has maintained its official interest rate within the range of 0%-0.25% to facilitate job creation and preserve price stability. The institution has also announced that it will continue reinvesting principal payments from agency debt and agency mortgage-backed securities, as well as extending the average duration for its debt portfolio (Operation Twist). However, given the obstacles faced by the US economy, in the last few weeks the number of voices has increased, both within and outside the institution, claiming the need for the Fed to introduce some additional monetary stimulus in the economy. The main proposals revolve around the possibility of the central bank opting to recompose assets via a further extension to its Operation Twist or replacing treasuries with mortgage bonds. The months of July and August have been a fertile field for debate and rumour regarding this issue. An official statement is expected at the meeting of 13 September, which will be followed by a press conference in which Ben Bernanke might provide some more details.
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China and Brazil lower their official interest rates to underpin economic growth.
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With regard to the situation in the emerging countries, as the months go by, the easing of monetary conditions is clearly becoming more intense and includes more and more countries. Economic indicators still show a weakening trend while inflation seems to be contained (although a problem has recently appeared in rising food prices, largely due to weather-related issues). Within this context, the main aim for central banks is to underpin growth, primarily by stimulating domestic demand, thereby offsetting the negative impact on their exports of the economic weakness in Europe and the United States. During the summer, the central banks of China and Brazil applied further quantitative easing measures. In China, the weakening of the main growth variables led its monetary authority to lower the official interest rate to 6%, as well as the deposit facility rate. In the case of Brazil, although this measure had largely been ruled out by investors, the central bank made its eighth cut in the official interest rate, down to 8%.
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Within this context, interbank interest rates for the euro area have tended to fall due to the cut in the official rate made by the ECB in July. Specifically, the 12-month Euribor rate has fallen to 0.89%, its lowest since the euro was created. Similarly, the ECB's decision to stop paying interest on the bank deposits it holds has sharpened the fall in the EONIA (the Euro OverNight Index Average) to 0.11%.
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The yield on Spanish debt reaches a peak and then relaxes
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The Euribor falls to its lowest level since the euro was created.
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The trend in debt markets in July and August was affected by the outcome of events in the periphery of the euro area and doubts regarding world growth. At a European level, investors have followed the Spanish economy very closely. The political backing received at the meeting of European leaders at the end of June and the ratification of the Memorandum of Understanding for Spain's bank bail-out, together with the new plan of fiscal reforms promoted by the government, did not manage to ease tensions concerning Spain's sovereign debt. Nervousness regarding Spain was fuelled by the uncertainty as to whether the country, with the announced measures and prevailing institutional framework, could break free from the vicious circle of debt, adjustments and recession. This feeling reached its peak when, in July, several autonomous communities asked the central government for financial aid, leading to a sharp rise in the yield on Spanish bonds. In particular, the yield for 10-year bonds reached its highest level since the euro came into force, namely 7.62%. In later weeks, and although doubts remained regarding the sustainability of public debt and access to funding in foreign capital markets, yields have fallen. This drop in the risk premium seems to be related to the possibility of the government requesting a second and more extensive bail-out, aimed directly at containing the cost of public debt and supported by actions by the ECB.
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At the same time, the debt of AAA-rated countries is benefitting the most from the credit turbulences in the south of the euro area. Needless to say, Germany stands out in this case. Since the end of June, the yields on German bonds have been at a record low, even offering negative interest rates on one and two-year bonds. Investor preference for high rated assets and the deterioration in global economic expectations are supporting this phenomenon. In the United States, the yields offered for its debt have remained within the minimum ranges. Factors such as the context of weak economic growth, the stability of inflationary expectations and the possible use of monetary stimuli by the Fed are helping yields to remain at these exceptionally low levels.
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The euro fluctuates violently
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The euro looks weak but benefits from a technical rebound.
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The events happening in the euro area over the last two months have been clearly reflected in the euro's exchange rate. The European currency came close to its lowest level against the dollar since 2010 as a consequence of incessant doubts regarding the future viability of European Monetary Union. By mid-July it was approaching 1.20 dollars. This trend was also due to the ECB's interest rate cut and the confirmation of the region's extreme economic weakness. The importance of this last aspect has been highlighted by the IMF in its last report on the world economic outlook and its growth, stating that action by Europe's political leaders is key to avoiding a prolonged recession. In fact, the euro did not only depreciate against the dollar. The exit of capital from euro-denominated money market funds to other, lower risk assets outside the euro area, and the reduction in euro reserves of central banks at a global level pushed up the value of currencies such as the pound sterling, Chinese renminbi and Japanese yen. In August, however, the euro saw a sharp upswing, so its rate against the dollar returned to the zone of 1.25. This movement seems to be technical in nature, a result of it being strongly over-sold and within a context of low trading volumes.
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More corporate bonds are being issued again
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The possible actions to be taken by central banks support corporate bond markets.
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Continuing the trend seen in previous months, two factors have affected the performance of corporate bond markets during the summer: developments in the sovereign debt crisis of the euro area and the revisions of forecasts for world economic growth. July and August have alternated protagonism and dynamism. In July, the increase in doubts regarding the sustainability of European Monetary Union led to an upswing in credit spreads. In August, the expectation that the main central banks would take action has given way to a phase of relative relaxation in risk premia. A large number of companies have taken advantage of this circumstance to issue bonds, supported by the attraction these assets offer investors, eager for safety and yields higher than those offered by AAA-rated sovereign debt. The volume of issuances in the United States and in the countries of northern Europe has been high, considering the period of the year in question. Taking advantage of the historical fall in interest rates for investment grade bonds and the echo of this trend in high yield bonds, the total volume of bonds issued by developed economies since the beginning of the year exceeds the total volume issued throughout the whole of 2011.
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Companies take advantage of lower interest rates to issue new debt.
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However, the situation is very different in the periphery of the euro area. The bond market has barely been active, due to two aspects: the uncertainty hovering over the future of these economies and the sharp reduction in ratings for the main firms. But the clearest example, once again, can be found in the financial sector. The crisis has led to issuances of senior debt barely managing to cover the maturities they are meant to cover. Similarly, issuances of covered bonds (represented mainly by mortgage-backed securities) have fallen by 50% since the spring.
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Uncertainty in the periphery of the euro area restricts firms' access to financing.
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On the other hand, the corporate bond markets of the emerging economies continue to benefit from the great resistance of their economies to the turbulences observed in the West. The continual arrival of foreign capital flows, attracted by a combination of good returns and safety, is supporting these markets. In particular, it's worth noting the spectacular increase in issuances by Chinese companies during the first half of the year (60% more than the same period a year ago). This increase highlights the liberalization process occurring in these markets and companies' decreasing dependence on bank loans.
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Stock markets go on holiday
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The corporate earnings season meets expectations.
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In spite of the continued fluctuations in the stock markets during the summer months, the net balance for the period has been slightly positive. Initially, confirmation of the slowdown in world growth and the deterioration in leading business indicators weighed heavily on share prices. But the situation improved as investors started to value the possibility that the central banks of the main economies might choose to employ further monetary stimuli. However, it should be noted that, over the last few weeks, stock markets have become increasingly volatile, due to the great uncertainty caused by events in the European crisis and the low trading levels of the holiday period.
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Ibex companies announce plans to reduce their debt.
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In the area of equity markets, another factor that has also boosted stock market trends is the corporate earnings season on both sides of the Atlantic. In the United States, in general terms, companies have not disappointed investors. They have announced earnings in line with expectations, even though sales have been affected by the economic slowdown in many cases. In the euro area, the sovereign debt crisis has started to take its toll on the earnings of some companies linked to the economic cycle. It has mainly been the shares from the financial sector that have recorded the largest fall in margins, due to their exposure to the debt of the region's peripheral countries and tougher regulations in the sector. In the case of Spanish firms, the quarter-on-quarter earnings of Ibex 35 companies have not disappointed. The relatively good performance by international activity has offset the weakness in the domestic economy. However, the deterioration in the local market, falling house prices, poor economic prospects and difficulty in accessing financing have led to a wave of deleveraging plans in most companies. In order to carry this out, companies are resorting to selling shares, modifying shareholder pay-out policies and refinancing the terms of their debt.
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The Spanish Securities and Investments Board bans the «short» selling of shares.
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Tensions due to uncertainty regarding the Spanish economy's capacity to meet the requirements imposed by Brussels have been the main limitation to the Ibex improving. Highly significant events, such as the approval of the recapitalization plan for the financial sector by Eurogroup and the ratification of Spain's rating at BBB+ by Standard & Poors have barely had any positive effect on the index. Given this circumstance, and in order to hinder opportunistic short-term investors, at the end of July the Spanish Securities and Investments Board (CNMV) imposed a ban on the «short» selling of shares.
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