BIS Quarterly Review June 2002 - International banking and financial market developments
27 May 2002
The BIS Quarterly Review is divided into two parts. The first part analyses recent developments in financial markets, financing flows and derivatives activity. The second part presents articles on topics of special interest. This issue offers three articles that examine different aspects of the functioning of US fixed income markets.
International banking and financial market developments
Waning confidence in strong recovery
The early months of 2002 dissipated the earlier ebullient mood that had built up in financial markets during the fourth quarter. From the start of the year to the first week of May, stock prices declined and US long rates edged lower with the waning of confidence in a strong economic recovery. In Europe, rising oil prices and new wage negotiations raised the spectre of inflation, pushing up long rates. In equity markets, investors' hopes were dashed by a lack of evidence that corporate earnings were recovering with the economy as a whole. Share prices were depressed further by continued scepticism about corporate disclosure and accounting practices, by new reports about stock analysts' biased recommendations and by a sudden aversion to corporations that relied heavily on short-term debt.
In spite of a relatively steep yield curve, large firms found the long-term debt market more hospitable than the short-term market. Some corporations could not issue commercial paper (CP) because of difficulty in obtaining backup facilities. In April, the largest provider of such facilities announced that it was pulling back from this business, effectively closing the CP market to many corporate borrowers. To obtain funds at short-term interest rates, some borrowers turned to the long-term market to issue corporate bonds and then converted their fixed interest payments into floating rate through the swap market.
Investors in emerging markets seemed to remain confident that a lacklustre recovery in the advanced economies would not undermine the growth prospects of certain favoured economies. Among the best performing stock markets were those of Mexico, Korea and Southeast Asian countries, which were seen as having the most to gain from an economic rebound in the United States. In spite of continuing economic problems in Argentina, sovereign spreads in general narrowed in an environment of low international interest rates.
The international debt securities market
The rebound in US economic activity during the first quarter of 2002 was not matched by an increase in the demand for international financing. Net issuance in the international debt securities market fell by 25% from the previous quarter. This decline, however, was due in large part to the fourth quarter being boosted by issues postponed after the terrorist attacks of 11 September. If not for this artificial strength in the fourth quarter, net issuance would have been roughly stable. Gross issuance actually grew moderately in the first quarter, but this growth was offset by a surge in repayments to record levels.
The first quarter also saw shifts in the maturity structure and mix of borrowers in the international debt securities market. While difficulties in the CP market continued to push borrowers to the long-term market, both financial institutions and corporate issuers reduced the net amounts of funds they raised in that market, with telecoms issuers conspicuously absent. By contrast, the market saw the return of emerging market borrowers, such as Brazil, China, Mexico and the Philippines.
The aggregate turnover of exchange-traded contracts monitored by the BIS declined slightly in the first quarter of 2002 following a record volume of activity in the previous quarter. The notional value of transactions slipped by 1%, in part because the absence of major policy rate moves brought a measure of calm to fixed income markets. Although trading in eurodollar futures remained buoyant, that in the options on those futures contracted sharply. This followed a year of intense hedging activity induced by a surge in US mortgage refinancing.
Equity index contracts were a notable area of trading activity. Trading in these contracts grew by 5% in the first quarter, with much of the increase coming from Korea and Japan. In Korea, trading in index derivatives expanded by 20%, making the Seoul marketplace the second most active after Chicago. Turnover in Korean contracts went hand in hand with a remarkable performance of the underlying equity market. In Japan, a sharp upswing in the trading of index contracts reflected a rebound from a near record low in January. Part of the surge in trading may have been induced by the new "uptick" rule for the cash market, with investors turning to the futures market for the short positions that had become difficult to take in the cash market.
The international banking market
In the fourth quarter of 2001, international banking flows to emerging economies increased for the second consecutive period. Net inflows totalled $25 billion in the fourth quarter, reversing outflows averaging $38 billion per quarter between mid-1999 and mid-2001. Claims on Southeast Asia increased for the first time since the financial crisis there. Flows to China and oil-exporting countries also turned positive, although this stemmed from a withdrawal of deposits rather than a rise in lending. Banks reduced their exposure to Argentina but increased their claims on Russia and other eastern European borrowers.
Despite the turnaround in flows to emerging economies, the growth of the international banking market continued to decelerate in the fourth quarter of 2001, held back by the global economic weakness. Inter-office transfers and increased purchases of US securities supported cross-border activity in the dollar market. In Europe, however, subdued corporate demand for bank credit and efforts by firms to reduce their reliance on short-term debt resulted in the first quarterly contraction in cross-border euro-denominated claims since European monetary union.
A box examines the surprisingly large build-up of foreign currency deposits in China over the past few years and traces their flow into the international banking system and overseas securities markets.
The changing information content of market interest rates
Two economists from the US Federal Reserve, Vincent Reinhart and Brian Sack, use the movements of five long-term US interest rates to extract information about five fundamental factors: the risk-free rate, liquidity preference, credit risk, shocks to the US Treasury market and shocks to the swap market. They then use such information to describe changes in the behaviour of US fixed income markets since autumn 1998, when Russia defaulted on its debt and the Long-Term Capital Management hedge fund nearly collapsed. One of their findings is that Treasury yields in recent years have varied more as a result of shocks specific to that market. They also find that corporate yield spreads have increasingly been affected by factors other than credit risk.
What's behind the liquidity spread?
Movements in the so-called liquidity spread have attracted much attention since the market turbulence of autumn 1998. This spread is measured by the yield differential between off-the-run and on-the-run US Treasury securities. Craig Furfine and Eli Remolona, both from the BIS, look closely at the trading activity that lay behind the dramatic movements of the spread during that autumn episode. It is not immediately apparent that trading activity shifted from off-the-run to on-the-run securities as suggested by anecdotal accounts. Only by focusing on the most recently off-the-run security and by accounting for various factors that affect trading are the authors able to document such a shift. They further find that the impact of trades on the price of both types of securities became stronger during autumn 1998, an indication of reduced liquidity during a period of stress. Significantly, the increase in the price impact was much more pronounced for the off-the-run note, implying that movements in the liquidity spread reflect changes in relative rather than absolute liquidity.
Positive feedback trading in the US Treasury market
Benjamin Cohen of the BIS and Hyun Song Shin of the London School of Economics study the price discovery process in the US Treasury bond market. They focus specifically on the short-term interactions between bond prices and buy and sell orders. Confirming results that have been established for stock markets, they find that trades have a strong impact on prices and that this impact is stronger on days when trading is relatively intense and volatile than it is on quieter days. More strikingly, they also provide evidence for episodes of positive feedback, in which traders reinforce price movements by buying when prices rise and selling when they fall, especially during times of volatile trading. This phenomenon, while taken for granted by market practitioners, has not yet been documented in the academic literature.