Quarterly Review, March 2007
14 March 2007
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 market activity. The second part presents five special feature articles: one on interpreting sovereign spreads; another on exchange rates and global volatility; a third on financial investors and commodity markets; a fourth on economic derivatives; and a fifth on measuring portfolio credit risk.
Markets rally until late February1
Prices of risky assets rallied between end-November and late February as the outlook for economic growth appeared to improve, while implied volatilities remained near record lows. In this environment, yields rose in major government bond markets, and perceptions grew among investors that monetary policy might turn out to be tighter in the foreseeable future than previously expected. In the United States, data releases indicated surprising strength in the economy, in particular during the first half of the period under review, leading to subsiding expectations among investors of a near-term lowering of policy rates by the Federal Reserve.
Corporate profitability and the ongoing strength of merger and acquisition (M&A) activity contributed to rallies in global equity markets. At the same time, spreads on risky corporate debt fell to all-time lows during the period, reflecting strong investor risk appetite, sound corporate balance sheets and surprisingly low default rates, particularly for higher-yielding credits. Spreads in some collateralised debt obligation (CDO) markets, mainly those centred on the housing sector in the United States, widened significantly over the past two months, possibly foreshadowing a broader turn in the credit cycle in the months to come.
As in high-yield credit markets in advanced economies, spreads on emerging market debt hit historical lows in the first two months of 2007, while equity prices continued to increase. Local events affected some individual countries negatively, but seemed to have little overall effect on investors' perceptions of emerging asset markets up until the last week of February. Instead, investors were largely anticipating continued strength in emerging economies in general, as well as an improving outlook for the US economy. The strong appetite for risk among investors is likely to have been another important factor behind asset price developments in emerging markets during the period under review.
Highlights of international banking and financial market activity
In the international debt securities market, gross issuance in the fourth quarter of 2006 increased by over 10% year on year. Debt outstanding grew by nearly $1 trillion to $18 trillion. The expansion was strongest in dollar-denominated securities, where the growth in gross issuance hit a five-year high. In the developed world, the euro area's share of securities issuance on a gross basis continued to climb, reaching 41% in the latest quarter. In emerging markets, issuers from Europe and Latin America were the most active.
Trading on the international derivatives exchanges slowed in the fourth quarter of 2006. Combined turnover measured by notional amounts of interest rate, currency and stock index derivatives fell by 7% to $431 trillion between October and December 2006, mainly because of a seasonal slowdown in the interest rate segment. By contrast, stronger activity was recorded in derivatives on stock indices (up 5%) and currencies (up 19%). Activity in futures and options on commodities, which are not included in the above total, increased by 12% in terms of the number of contracts traded, mainly reflecting a sharp rise in the trading of agricultural commodities in China.
In the international banking market, the stock of cross-border claims of BIS reporting banks reached $25 trillion in the third quarter of 2006. The 16% year-on-year growth in claims was up slightly from the previous quarter but was still in line with historical averages. Growth was particularly robust for sterling- and dollar-denominated claims. Banks in the United Kingdom were responsible for over half of the developed world's growth in claims. The emerging markets were strong net depositors, with reporting banks' net claims on those markets decreasing by $64 billion.
The consolidated banking statistics, which are compiled according to the nationality of reporting banks and net out inter-office positions, show that the expansion of foreign claims in the third quarter of 2006 was driven mostly by French, UK and Swiss banks. New claims were extended primarily to borrowers in the United States, emerging markets and the euro area. On an ultimate risk basis, reporting banks increased their exposures to almost all countries, in spite of political and military tensions in a number of countries. Risk transfers continued to play a relatively small role in reporting banks' portfolio exposures to emerging markets.
Recent years have seen a substantial and steady narrowing of sovereign spreads in emerging debt markets. Drawing on the asset pricing literature, Eli Remolona and Michela Scatigna of the BIS and Eliza Wu of the University of New South Wales propose an analytical framework for interpreting sovereign spreads. Sovereign spreads can be broken up into two components: the expected loss from default and the risk premium, with the latter reflecting how investors price the risk of unexpected losses. The authors show that risk premia account for the larger part of average sovereign spreads, even during a period when such spreads have been relatively low.
During the sell-off of emerging market assets in MayJune 2006, higher-yielding currencies depreciated the most. Investigating the relationship between exchange rates and global volatility, Corrinne Ho and Robert McCauley of the BIS and John Cairns of IDEA Global document that, at times of heightened global equity and bond market volatility, high-yielding currencies generally tend to depreciate against the US dollar while low-yielding ones tend to serve as a "safe haven". Much of the cross-sectional pattern of currency sensitivities to global volatility can be accounted for by the level of short-term interest rates and, to a lesser extent, the scale of net international liabilities. The authors conclude that the convergence of inflation rates in Asia is likely to narrow the differences in the response of various currencies in the region to a change in global volatility.
In recent years, commodities have attracted considerable interest as a financial investment, with increasing diversity in both the instruments and strategies used. Dietrich Domanski and Alexandra Heath of the BIS investigate the factors behind the growing appeal of commodity markets and assess the extent to which market characteristics, such as price volatility, have changed as a result. From this analysis, the authors conclude that commodity markets have become more like financial markets in terms of the motivations and strategies of participants. Nevertheless, the physical characteristics of commodity markets, such as inventory levels and marginal costs of production, remain important influences on how these markets function.
Economic derivatives allow traders to take direct positions on the outcomes of macroeconomic data releases. Analysing the motives for trading such contracts, Blaise Gadanecz, Richhild Moessner and Christian Upper of the BIS document that the prices of more conventional and liquid financial contracts often respond in unpredictable ways to announcement surprises, thus making economic derivatives more suitable for taking positions on data releases. The authors also note that, in contrast to survey-based measures of market expectations, the prices of economic derivatives provide information on the entire probability distribution underlying these expectations, not just point estimates. They conclude that measures of uncertainty derived from such distributions offer valuable information on how uncertainty about the economy evolves and affects financial markets.
A model-based assessment of credit risk is subject to both specification and calibration errors. Focusing on a well known credit risk model, Nikola Tarashev and Haibin Zhu of the BIS propose a methodology for quantifying the relative importance of alternative sources of such errors and apply this methodology to a large data set. The authors find that flawed calibration of the model can substantially affect the measured level of portfolio credit risk. By contrast, misspecification of the model has a more limited impact, especially for large, well diversified portfolios.
1 The period covered in the Overview is from end-November 2006 to 23 February 2007.