Quarterly Review, September 2008
The BIS Quarterly Review released today is divided into two parts. The first presents an overview of recent developments in financial markets, before turning in more detail to highlights from the latest BIS data on international banking and financial activity. The second part presents four special feature articles: the first on the inflation risk premium in the term structure of interest rates; another on the development of money markets in Asia; a third on foreign exchange settlement risk; and a fourth on the determinants of the returns of ABX indices, an important barometer of subprime mortgage market conditions.
Markets adjust to cyclical downturn1
During the period from end-May to late August 2008, global financial markets adjusted to growing signs of a broad-based cyclical deterioration. While markets continued to display signs of fragility, worries about the economic outlook and related uncertainties gained prominence, weighing on valuations across asset classes.
Credit markets came under renewed pressure over the period, as spreads widened to reflect the implications of the ongoing cyclical adjustment for loss expectations and financial sector balance sheets. This was despite retreating oil and commodity prices, government action in support of the US housing market and continued recapitalisation efforts by banks and other financial firms. Equity markets reflected similar concerns, as valuations adjusted to reflect disappointing earnings data, including in the financial and other cyclical sectors. Against this background, pressures in interbank money markets persisted, prompting further central bank action to ease financial sector access to funding.
As market expectations regarding price levels and monetary policy shifted against the backdrop of changing oil and commodity prices, government bond yields moved to price lower short-term growth prospects and the possibility of higher inflation in the longer run. Worries about inflationary pressures and deteriorating external financing conditions also weighed on emerging market assets, before declining oil and commodity prices seemed to provide temporary relief. With weaker macroeconomic conditions thus moving more clearly into focus, equity prices declined and emerging market spreads increased, although to varying degrees across countries and regions.
Highlights of international banking and financial market activity
In the international debt securities markets, borrowing recovered sharply in the second quarter of 2008 despite the continued turmoil in financial markets. Net issuance of bonds and notes increased to $1,071 billion, up substantially from $371 billion in the first quarter and recovering almost to the level recorded just before the recent turmoil began (the second quarter of 2007). The increase came chiefly from the euro-denominated bond segment, where net issuance of $464 billion was more than four times the level of the previous quarter. Mortgagebacked bond issuance rose markedly, particularly in the United Kingdom, following the Bank of England's announcement in April 2008 of a Special Liquidity Scheme that enables UK banks to swap illiquid assets such as mortgage-backed securities for UK Treasury bills.
Trading on the international derivatives exchanges retreated in the second quarter of 2008. Total turnover based on notional amounts decreased from the high of $692 trillion recorded in the first quarter to $600 trillion. Most of the contraction came from derivatives on short-term interest rates, but turnover also declined in derivatives on long-term interest rates and stock indices. By contrast, turnover in derivatives on foreign exchange was robust, up over the previous quarter's level and increasing by as much as 44% year on year. Turnover in derivatives on commodities, measured only in terms of the numbers of contracts, dropped, although year-on-year growth remained quite high at 37%.
Growth in international bank claims continued to slow in the first quarter of 2008. BIS reporting banks' gross international claims on non-bank borrowers expanded by $365 billion, the smallest first quarter increase since 2003. Reporting banks continued their net transfer of funds out of the United States, a trend evident since the onset of the financial turmoil in mid-2007. Though loans to non-banks expanded, banks' outstanding debt securities claims on non-banks fell significantly, by $98 billion, the first quarterly decline since the first quarter of 2001. At the same time, reporting banks' total deposit liabilities vis-à-vis official monetary authorities dropped noticeably in the first quarter, by $38 billion to $1.44 trillion, in part reflecting movements in foreign exchange reserves placed in commercial banks abroad.
Special features
The inflation risk premium in the term structure of interest rates
Break-even rates derived from inflation-linked securities markets are increasingly used as indicators of inflation expectations. However, since break-even rates reflect both expected inflation and risk premia that compensate investors for inflation risk, the identification and quantification of such premia are important. Building a dynamic term structure model based on an explicit structural macroeconomic framework, Peter Hördahl of the BIS estimates inflation risk premia in the United States and the euro area. He finds that inflation risk premia have been relatively small but positive over the past decade, and have exhibited an increasing pattern with respect to maturity for the euro area and a flatter one for the United States. Mr Hördahl also finds that inflation risk premia tend to vary over time, mainly in response to fluctuations in economic growth and inflation.
The development of money markets in Asia
The depth and breadth of money markets in Asia have improved significantly over the past decade, yet many are still characterised by segmentation and a low degree of cross-border integration. In their overview of the development of money markets in Asia, Mico Loretan and Philip Wooldridge of the BIS find that the underdevelopment of Asia's money markets actually worked to the region's advantage during the recent turmoil by insulating it to some degree from the shocks that disrupted more developed money markets. Nonetheless, the turmoil provides authorities and market participants in Asia with an opportunity to learn from experiences elsewhere in their efforts to realise the full benefits offered by well functioning money markets.
Reducing foreign exchange settlement risk
Much progress has been made in reducing settlement risk in foreign exchange markets, particularly since the establishment of a specialised settlement institution (CLS Bank) in 2002. In his special feature, Robert Lindley of the BIS examines the results of a survey carried out in 2006 for the Committee on Payment and Settlement Systems (CPSS) by 27 central banks. FX settlement exposures are sometimes still significantly large and not always well managed. The author concludes that it is particularly important that prudential regulators promote effective management of the risk by market participants.
The ABX: how do the markets price subprime mortgage risk?
ABX indices, which are based on credit derivatives written on mortgage-backed securities, have become a key barometer of subprime mortgage market conditions during the recent financial crisis. After providing a brief overview of ABX indices and how they work, Ingo Fender of the BIS and Martin Scheicher of the ECB apply regression analysis to investigate the relationship between observed index returns and proxies of default risk, interest rates, market liquidity and risk appetite. The authors conclude that declining risk appetite and heightened concerns about market illiquidity have provided a sizeable contribution to the observed collapse in ABX prices since the summer of 2007.
1The period covered in the Overview is from end-May 2008 to 22 August 2008.