September 2016 BIS Quarterly Review: Markets pass Brexit test

Markets recovered quickly from the shock of the Brexit vote. Central banks have exerted a calming influence and have eased further in recent months as dissonant markets raised questions about the outlook and the pricing of underlying risks. 

"There has been a distinctly mixed feel to the recent rally - more stick than carrot, more push than pull, more frustration than joy. This explains the nagging question of whether market prices fully reflect the risks ahead," said Claudio Borio, Head of the Monetary and Economic Department. "Doubts about valuations seem to have taken hold in recent days. Only time will fully tell."

The September 2016 issue of the BIS Quarterly:

• Introduces four enhancements to published BIS data: expanded country-level details on cross-border banking flows; long-term series for credit-to-GDP gaps - an early warning signal of banking stress - and for commercial property prices; and historical consumer price data, dating as far back as 1661. In addition, the BIS is publishing daily data on nominal effective exchange rates for 61 countries. These new series will be available online and regularly updated.
• Shows that year-on-year growth of US dollar bank loans to borrowers outside the United States turned negative in the first quarter of 2016 for the first time since 2009, the time of the financial crisis.
• Explores the United Kingdom's role as a hub for international banking. Cross-border borrowing and lending by banks located in the United Kingdom, or UK branches of foreign banks, are notably larger-scale than the cross-border business of banks with headquarters in the United Kingdom.
• Documents the trend of non-financial companies issuing debt in euros rather than US dollars as they take advantage of lower borrowing costs and the ECB's asset purchases. Euro-denominated bonds are accounting for an increasing share of net issuance in international debt securities, including for US and emerging market borrowers.
• Discusses the strong growth of over-the-counter markets in derivatives trading, drawing on the recent BIS Triennial Survey of Foreign Exchange and Derivatives Markets Activity. 

Four special features examine developments in currency and bond markets:

• Claudio Borio, Robert McCauley, Patrick McGuire and Vladyslav Sushko (BIS)* explore the breakdown of the closest thing to a physical law in international finance: covered interest parity (CIP). By analysing data on currency hedging by banks, institutional investors and non-financial firms, they find that the CIP breakdown reflects growing demand for such hedging using FX derivatives in a low interest rate environment. They argue that stricter risk management and balance sheet constraints limit profit-taking opportunities and allow the breakdown to persist.
  
  "The persistent deviation from covered interest parity may not be a concern for policymakers in itself, but policymakers should take note of it as an indicator of the health of the banking sector. If banks put such a high price on balance sheet capacity when the financial environment is largely tranquil, what will happen when volatility picks up?" said Hyun Song Shin, Economic Adviser and Head of Research.

• Dietrich Domanski, Emanuel Kohlscheen and Ramon Moreno (BIS)* examine how financial stability concerns have become an increasingly important driver of central bank currency market intervention since the financial crisis. When trying to stabilise markets, central banks face a trade-off between keeping them liquid and maintaining strong currency reserve buffers, which influences the tools they use in currency intervention.
• José María Serena (Bank of Spain) and Ramon Moreno (BIS)* find that limited local financing opportunities encourage emerging market firms to issue debt offshore. The analysis also finds that these firms appear to use the proceeds to buy short-term assets, creating a possible vulnerability in the financial system.
• Stefan Avdjiev, Agne Subelyte and Előd Takáts (BIS)* analyse expanded BIS banking data and find that cross-border lending in euros increased as the euro depreciated around early 2015, the period in which the ECB announced quantitative easing measures. The rise was most marked for lender-borrower pairs which already had a large share of claims in euros and for advanced economies outside the euro area. This illustrates how ECB monetary policy can have effects well beyond the borders of the euro zone.

* Signed articles reflect the views of the authors and not necessarily those of the BIS.